Japanese equities have continued rising over recent months, with the Nikkei 225 breaching its 1989 peak and climbing above the psychologically important 40,000 for the first time in history. While this resurgence is capturing attention, what is potentially more significant is the fact that over the next five to ten years, many of the factors that have held back the region’s equity returns for so long are likely to change.

Japanese equities have been on a tear for more than a year, driven by a combination of strong corporate earnings, a weaker yen that helps exporters, and an influx of foreign investors looking for an alternative to China. Looking forward, we see three key factors supporting a longer-term renaissance, namely improving corporate governance, reflation, and changing monetary policy and yen appreciation. All have the potential to generate traction for increasing capex (future digitalisation, new supply chains in manufacturing and logistics) and higher domestic consumption.

After decades of deflation, rising productivity growth and inflationary conditions could boost earnings growth; meanwhile, greater corporate efficiency and improved governance could raise profitability, valuations and dividend income. 

As a further driver, with more companies passing on inflation costs to consumers, labour unions were able to secure the biggest payrise for Japanese workers since 1991. This appears to have given Bank of Japan officials confidence that mild inflation will continue to remain stable and at its March meeting, officials ended eight years of negative interest rates and also removed yield curve controls.

While company fundamentals should become more relevant in Japan, we also note the US Federal Reserve’s hiking cycle is coming to an end. Together with gradual BoJ policy normalisation, that would be expected to drive a narrowing of the yen-USD interest rate differential and yen appreciation. Our team believes this environment could benefit ‘quality-growth’ stocks in Japan with domestic exposure, across areas such as precision instruments, electric appliances, chemicals and the service sector.

Given all these factors, we believe a core, well-diversified multi-cap strategy is worth considering for investors re-evaluating their asset allocation in order to address a long-term underweight exposure to Japan.