Economic Commentary

Will the BoJ scupper Japan’s stock market rally?

In the world of finance, Japan has been making history in recent weeks. In February, the main Japanese equity index, the Nikkei 225, hit a record high, surpassing levels last seen in 1989. And on 19th March, the Bank of Japan (BoJ) raised interest rates for the first time in 17 years, ending its longstanding negative interest rate policy (NIRP). The BoJ’s unorthodox policy of applying a -0.1% interest rate to excess reserves deposited at the central bank has gone, and the bank will now target a new policy rate (the overnight call rate) in a range of 0.0-0.1%1.

In the grand scheme of things a rate hike of 10-20 basis points, in itself, would not appear to be a big deal. However, with lose monetary conditions having been a significant driver of the rise in Japanese equity markets in recent years, investors are asking whether a policy shift from the BoJ might potentially scupper the rally.

There is little doubt that the Bank of Japan’s ultra loose monetary policy has played a role in lifting Japanese equities. While most developed market central banks have been raising interest rates in recent years to combat the post-pandemic spike in inflation, the BoJ kept its main interest rate at -0.1%.  Along with its policy of yield curve control (whereby the authorities seek to keep the yield on the 10-year Japanese government bond below a certain level – see our Commentary of May 2023), the NIRP kept Japanese monetary policy relatively loose, and consequently put downward pressure on the Yen.

In turn, this has benefited Japanese exporters, making their products more competitive in overseas markets and boosting their share prices. 
Indeed, there has historically been a fairly close inverse relationship between movements in the Yen and moves in Japanese share prices.

The 34% rise in Japanese equities since the start of 2022 has coincided with a fall of around 29% in the Yen’s exchange rate against the US dollar2. As a result, Japanese equities have only delivered a return of around 5% in US dollar terms over the period. In Sterling terms, the return is somewhat better, around 10%. 

These findings raise two broad questions regarding the outlook for Japanese equities: firstly, what are the chances that we see an aggressive tightening in monetary policy and a strong appreciation of the Yen which negatively impacts profitability and stock market performance; and secondly, are there other factors that could be supportive of equity prices, counteracting the potential headwind from tighter monetary conditions and a less competitive exchange rate. 

Policy to remain accommodative

Take monetary policy first. Along with the exit from NIRP, the BoJ also announced that it would abandon its yield curve control policy and would also stop purchases of Japanese equity exchange-traded funds (ETFs) and real estate investment trusts. However, the BoJ did say it would keep buying “broadly the same” amount of government bonds as it did before,  and would increase purchases if required to prevent a sharp rise in yields. Importantly, the BoJ also indicated that “accommodative financial conditions will be maintained for the time being”3.

In light of this guidance, and given lacklustre economic activity, high public debt and relatively low inflation (of around 2%4) compared to other advanced economies, a marked tightening in monetary policy does not appear to be on the cards.  Even though market interest rates have risen in recent weeks to reflect the growing likelihood of a policy move by the BoJ, they are still historically low. The yield on the 2-year Japanese government bond (which is sensitive to movements in policy interest rates) has risen by about 12 basis points since the start of 2024 but is still only 0.17%5. This suggests that the market does not expect rates to rise much during the coming years and real (i.e. after inflation) interest rates will remain negative for quite some time.

In turn, continued monetary accommodation from the BoJ should work against a sharp appreciation of the Japanese currency. Indeed, the outlook for the Dollar-Yen exchange rate will probably be influenced more by the decisions of US policymakers rather than their counterparts in Tokyo.  Sharp interest rate cuts in the US could potentially weaken the US dollar and result in a stronger Yen. However, with US inflation proving stubborn, the Federal Reserve will be wary of a dramatic loosening in monetary policy while the US economy remains resilient.  As it stands, it is difficult to envisage a marked strengthening in the Yen resulting from interest rate differentials. 
Even if the Yen does appreciate on the foreign exchanges and hurt exporters’ earnings, other factors could provide an offsetting tailwind for Japanese equities.

Corporate governance reforms

Firstly, the corporate governance reforms implemented by the Tokyo Stock Exchange (TSE) in recent years still have scope to boost shareholder returns. Since 2015 the government and the TSE have implemented a series of measures designed to improve the transparency, accountability and performance of listed companies, with a view to unlocking value for shareholders. Over the last year or so the TSE has prompted Japanese listed firms to increase capital efficiency and called on companies whose shares are trading with a price-to-book (P/B) ratio of less than 1 (i.e. the company’s shares are trading below their book value, or the net value of its assets minus liabilities on its balance sheet) to outline measures to improve valuations.

One way a company can improve its price to book ratio is to increase its returns to shareholders via dividends or share buybacks. There is strong evidence that this is happening. In 2023, share buybacks by Japanese listed companies hit a record high of Yen9.6 trillion6. Further gains could be in store. Although the number of companies in the Nikkei 225 with a P/B ratio less than one has fallen, they still comprise about 35% of the index, compared to around 3% of the top 500 listed companies in the US7. Moreover, with Japanese companies still holding a lot of cash on their balance sheets, and profits forecast to rise around 8% this year8, there are good prospect for buybacks and dividends to increase further. 

From deflation to inflation

Assuming the BoJ can keep inflation around its targeted 2% mark going forward, Japan’s transition away from an era characterized by periodic bouts of deflation (i.e. falling prices) towards one of sustained positive inflation should be supportive of the equity market. Positive inflation suggests stronger corporate pricing power and higher rates of nominal GDP growth, on which domestic sales (and by extension profits) depend. 

Moreover, while deflation gives households and businesses an incentive to delay purchases (in the expectation that goods can be bought more cheaply at a later date), the return to sustained, positive inflation could encourage consumers and firms to go out and spend. Stronger household spending and business investment could in turn boost growth and corporate revenues. 

The exit from deflation could also encourage Japanese households to move more of their assets from bank deposit into equities. Scarred by the collapse of the 1980s stock market bubble, Japanese households currently allocate just 24% of their assets to equities, compared with 54% in the UK and 75% in the US9. The flip side of this is that they hold around half of their financial wealth in cash and bank deposits, a sum equivalent to nearly US$8 trillion. Holding such large sums on deposit is not such a bad idea when prices are falling, but it is not wise when prices are rising and inflation is eroding the real value of cash. If Japanese households move their savings into equities (which generally have a better chance of generating inflation-beating returns over the long-run than cash) the inflows could provide a sustained fillip to the domestic stock market. 

Asset allocation shift

The government has been trying to encourage this shift via the Nippon Individual Savings Account (NISA), a tax-exempt savings wrapper modeled on the UK ISA. The NISA has been around since 2014, but changes introduced at the start of 2024 trebled the limit on annual contributions to Yen3.6 million (approximately £18,800) and raised the maximum total contribution to Yen18 million. The changes appear to be boosting uptake, with some 900,000 new NISA accounts opened in January10.

There is no requirement for NISA funds to be invested in the domestic market, and there is some evidence to suggest that Japanese retail investors have preferred to direct funds to the US11. However, estimates from Alliance Bernstein suggests a 2% reallocation of assets to Japanese equities could produce flows of US$150 billion – a market-moving amount according to some brokers12. The combination of more shareholder-friendly policies from Japan Inc., a return to inflation and a firmer Yen exchange rate could favour such a reallocation. 

Relatively attractive valuations for Japanese equities should also be supportive. Japanese equities trade on a forward price to earnings (P/E) ratio of 15.713, considerably lower than the 21.0 equivalent multiple of the US market14. Moreover, the dividend yield of 2.0% on Japanese equities not only compares favourably to the yield on the 10-year Japanese government bond of 0.7%, but is also higher than the 1.4% dividend yield on US equities15

A gamechanger?

All things considered, it appears unlikely that BoJ policy will, in itself, scupper the recent run in the Japanese stock market. Interest rates might inch up further, but policy is likely to remain loose, especially compared with the US. Against this backdrop, the degree to which the Yen strengthens and hurts the earnings of Japanese exporters should be contained. And on the plus side, the move to positive interest rates will boost revenues in the banking sector.  

More generally, if the transition from deflation to inflation can be sustained, it bodes well for economic growth and a shift in retail asset allocation away from cash and towards equities, which is also being supported by structural reforms. While the Bank of Japan’s exit from NIRP brings an end to the era of unorthodox monetary policy accommodation, it need not be a bad omen for the Japanese equity market.

19th March 2024

2 FE Analytics
15 JP Morgan Equity Strategy Chartbook March 2024