Many people found it hard to accept because Japan was still the world's second-largest economy behind the United States. Indeed, at $4.2 trillion, it was nearly three times China's GDP. Even back then, there was a school of thought that wonderful things were in store for Japan if only it could shift from its reliance on industrial manufacturing to an economy balanced by domestic demand and service industries.
But the Nikkei 225 Index had fallen 75% in ten years, and in the wake of the Asian Crisis in 1998, the headline seemed to perfectly capture the moment of maximum market pessimism with leading commentators saying Japan was finished, soon to be replaced by China as the prominent Asian growth story.
There was some justification for the gloomy outlook. The Japanese economy had stalled after the bursting of the property bubble in 1989, leading to years of weak growth and deflation.
To give some context to the absurdity of that bubble, at its peak, it was widely reported that the grounds of the Imperial Palace in Tokyo, an area of less than ½ square mile, was worth more than all the real estate in California.
The big Japanese banks, having been inextricably linked as they were to the property bust, were totally impaired, burdened by bad loans and unable to support any economic expansion. Every sector of the economy was affected, and all of this was reflected in the stock market. For years, foreign investors and institutional asset allocators viewed Japan as a value trap; the market looked cheap, and full of world-class companies, but never seemed to recover sustainably for any length of time.
Indeed, it gave rise to the slightly perverse situation where Yen weakness was often viewed as the only catalyst to buy the market because the currency effect boosted the foreign income, and therefore profits, for the large-cap exporters like Canon, Toyota and Sony who had export ratios in excess of 80%.
With the stock market often at the whim of the fluctuations in the Japanese Yen, investors commitment to the stock market was wafer-thin. Every now and then, when foreign investors appeared to re-engage with Japanese equities, encouraged by bullish headlines such as “The Sun Also Rises”, they were actually just dancing near the door and were quick to take profits. The whole thing contributed to a chronic underweight of Japanese equities in global portfolios for years. Something had to change.
That change came in the form of the economic program launched by Japanese Prime Minister Shinzo Abe after he returned to power in December 2012. It involved money-printing on a massive scale, spending programs with stimulus packages and structural reform. The strategy was officially called “The Three Arrows” but became known as “Abenomics”.
The intervention turned Japan from a market largely ignored by investors into one of the world's biggest reflation trades. Foreign investors poured money into Japanese equities, exporters benefited from the weaker currency, and corporate governance reforms gradually encouraged companies to focus more on shareholder returns.
It was a good start, but it didn’t all go to plan. Raising taxes twice in the middle of it all was a policy error and the idea of structural reform felt distinctly unrealistic to a corporate culture clinging on to a tradition resistant to change. Economic growth remained modest by international standards. Improvements to productivity were limited and wage growth was weaker than hoped for.
These factors remained so embedded in the economy that, 10 years later, Japan sailed through the inflationary aftermath of the Covid pandemic that was so troublesome for the rest of the G7. Whereas the central banks of the US, UK and Europe all had to aggressively raise interest rates from 2022 onwards to battle rampant global inflation, the Bank of Japan kept interest rates, almost unbelievably, at minus 0.1%.
The interest rate differential with the rest of the world weakened the Yen, which inevitably led to Japan importing lots of global inflation. But in the spring of 2024, slightly fortuitously, it kick-started the largest annual pay demands for 30 years. In short, workers got higher pay, consumers spent more and companies felt able to raise prices. Convinced that Japan was finally escaping its long-running deflation trap, the Bank of Japan found the confidence to start the journey back to more normalised interest rates with a base rate hike to a largely symbolic 0.1%.
But the message was clear and, unlike the other main central banks who had to say their actions were in response to out-of-control inflation, the Bank of Japan could spin the line that all of the negative interest rates, money printing and other extraordinary measures had largely, and finally, fulfilled their purpose.
Since then, it is evident that inflation is being driven increasingly by domestic demand and services rather than imported energy and goods costs. For Japan’s government, central bank and even corporations, the elusive dream of self-sustaining wage-price cycle has become a welcome reality.
If one is looking for evidence that this time really is different, a quick look at government bond yields among the G7 economies is revealing. Six months ago, as we entered the new year, the Japanese 10-year bond yield was 1.55% versus the German 10-year yield of 2.86%. Today, the Japanese yield has risen dramatically to 2.62% with the German yield virtually unchanged at 2.87%. Furthermore, and unlike previous cycles, this has happened without tripping up the Japanese stock market where the headline Nikkei index is up nearly 40% year to date.
Of course, the AI and semiconductor boom has had something to do with it. Japan is, and always has been, a leader in advanced electronics and those sectors have led the index upward, beating even a resurgent banking sector.
Stocks like Shin-Etsu Chemical and Kyocera may not be household names but their expertise and involvement in component manufacturing of silicon for semiconductor chips, ceramics and other critical parts, make them key to the infrastructure build out for AI data centres. They are just some of the names that we monitor closely in the funds in FIM client portfolios.
But away from the AI theme, there has been a fundamental change taking place in corporate Japan. Some corporate behaviour has been influenced by the Tokyo Stock Exchange itself which has forced companies trading on a price-to-book value of less than 1x, typically those sitting on large cash deposits or lazy balance sheets, to publish their plans for investment for improving returns. The name-and-shame nature of the disclosures appear to be working and may be evidenced by dividend payments, and share buybacks, that now account for double the total returns than they did 10 years ago; something unimaginable at the turn of the century.
It’s been a long time coming. But those with a long enough memory will remember what it was like trying to invest in Japan back then and will see that, this time, it really is different.
- Christian Holland, Investment Change Delivery Manager
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