Thought of the day

The Bank of Japan (BoJ) has taken a historic step, implementing its first hike in 17 years, and ending an eight-year stretch of negative interest rates. Other aspects of Japan’s ultra-easy monetary policy were also abandoned, including a yield-curve control policy aimed at keeping the 10-year government bond yield near zero. The central bank also said it would stop buying exchange traded funds (ETFs).

The move followed further evidence that Japan’s decades-long struggle with deflation is coming to an end. Core consumer price inflation has now been above the central bank’s 2% target for 22 consecutive months. Meanwhile, the 2024 Shunto wage round—the annual negotiation between Japanese employers and unions—delivered an increase of 5.28% among large companies, the biggest pay rise in 33 years.

But while the Bank of Japan’s decision marks the end of a monetary era, we do not think it will end the bull market in Japanese stocks, which have been a strong performer both this year and last:

While we expect the yen to strengthen in the remainder of 2024, we don’t expect an excessive appreciation to dent stocks, which have benefited from a weak currency. This view was underlined by the early market reaction. The yen actually fell versus the US dollar on the news, with USDJPY moving above 150 for the first time in two weeks, and the 10-year yield moved lower. We do expect the yen to appreciate as the Federal Reserve cuts rates this year, pushing the yen toward 140. That is quite manageable for Japanese equities. Although we acknowledge the risk that the Bank of Japan could tighten policy further if inflation continues to rise, our base case is that the central bank will keep policy accommodative, limiting upward pressure on the yen. With food inflation likely to gradually slow, we expect core consumer price inflation to drop to around 2% by the year-end and to 1.5% by the mid-2025.

Japan’s equity rally has the potential to broaden as international investors gain confidence in Japan’s inflation dynamics and corporate reform progress. More corporate governance catalysts could emerge during the full-year results season in April–June as companies disclose their plans to improve corporate value, deliver share buybacks, and unwind cross-shareholdings. The latter started to emerge in recent months, triggered by announced sales of some JPY 7tr in strategically held shares by major non-life insurers expected to broaden across sectors and drive earnings per share growth for Japanese equities over the medium term. In addition, we don’t expect a major drag from the ending of the BoJ’s purchases of exchange traded funds (ETFs), which was being used only sparingly. The central bank bought only JPY 210bn in 2023 and none in 2024.

Earnings growth looks likely to remain solid, and valuations are not overly demanding. We expect solid corporate earnings growth of 12% and 5% for the 2023 fiscal year (year-end March 2024) and the 2024 fiscal year, respectively. Although, valuations are no longer cheap—at 15.5 times forward earnings, which is above the historical average of 13.7 times—this is still fair value compared to the MSCI ACWI (17.7x) and S&P 500 (21x), with Japan’s price-to-earnings discount compared to both markets still greater than the long-term average.

So, while we are neutral on Japanese stocks, we do believe the rally can run further. To capture further upside, we like beneficiaries of the domestic recovery and corporate governance reforms. These include large-cap banks, which we expect to benefit from improving economic fundamentals. The real estate sector, one of the biggest laggards under deflationary conditions, also has the potential to regain ground. We also like cyclical stocks, which have underperformed over the past two years despite an above-average earnings growth outlook for the current fiscal year.