Rising Above: Unleashing the Potential of Japanese Stocks in an Unprecedented Year

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Japanese stocks have a unique ability to turn people into professional cynics. Hence, it is fitting that after months of gains, some investors are beginning to question if this notoriously fickle market has gone too far.

Reaching this point is ironic. It has taken over 30 years for the Topix and Nikkei indices to recover from the market’s spectacular crash, with both still below the 1990 highs. False dawns have made many money managers reluctant to engage for years.

One fund manager described his efforts to generate returns from this market as a “misspent youth”. Fun in fast cars and dingy bars might have been more enjoyable.

However, everything has aligned this year, defying the consensus that 2023 would be similarly unimpressive. The Topix and Nikkei 225 have both gained over 20% so far, making this a breakout year.

Monetary policy has played a significant role. The Bank of Japan has maintained its benchmark rate below zero and capped bond yields, contrary to other developed countries, as it seeks to escape rock-bottom low inflation. The rise in inflation has led to a shift in the mindset of corporate Japan. Although the extent of the yen’s impact on stocks is debated, its depreciation has benefited exporters.

The main support, however, comes from the government’s increased focus on corporate reform and fostering a healthier capital market with greater retail participation.

Leading global investors have taken the bait. BlackRock, the largest of them all, announced this month that it would increase its allocation to Japan, investing more in the country’s stocks than benchmarks suggest. According to the BlackRock Investment Institute, the global market environment with high interest rates, sluggish economic activity, and persistent inflation undermines many key equity markets. However, they see Japan as different, with strong earnings, share buybacks, and corporate reforms that make it an attractive investment opportunity.

UBS Wealth Management also stated that equity investment flows into Japan have surpassed those into China for the first time since 2017. Chief Investment Officer Mark Haefele wrote, “We think Japan is still under-owned and under-appreciated by both global and domestic investors compared to history.” Bank of America’s regular fund manager survey shows that investors currently maintain their largest overweight position on Japan since 2018.

So, what’s causing the apprehension? Zuhair Khan, a fund manager at Swiss private bank Union Bancaire Privée, welcomes the increased interest in Japanese stocks but finds it a bit worrisome due to the influx of investors. His fund takes positive bets on Japanese companies that demonstrate progress in corporate governance, but he also takes negative bets (shorts) on those resistant to change. Despite positive corporate reforms, Khan finds that the rally this year has inflated valuations of companies merely paying lip service to the agenda, presenting opportunities to profit from short positions.

Bank of America’s survey also reveals that investors consider Japanese stocks as the world’s third most crowded bet, ranking behind US technology stocks and the negative bet on China but still towards the top.

Peter Tasker, an experienced veteran in this market, agrees that the inflow of capital this year has created a somewhat bubbly mood. However, he emphasizes that it pales in comparison to the situation in the US. Arcus Investment, which Tasker co-founded in 1998, believes that Japan now offers a long-awaited opportunity for investors.

According to investors, the biggest risk to Japanese stocks is a significant global economic slowdown, which would also impact other major markets. Any doubts about excessive enthusiasm are seen as a compliment, indicating that investors are scrutinizing this market just like any other.

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