A battle for investors’ money outside of the US has been between Europe and Japan. Both have traditionally been beneficiaries of the global economic recovery phase and are considered more cyclical markets. With investors starting to reconsider their long-standing love affair with US equities1, especially with the US dollar being more volatile and share price weakness among some of its largest companies, could Japan still have a place in portfolios?
Both European and Japanese markets have had a difficult run, but Japan in particular has struggled. The Bank of Japan maintained its loose monetary policy even as interest rates rose in other major markets around the world. This put significant pressure on the yen, which was down as much as 30% at one point versus the US dollar in 20222, denting returns for international investors.
The Bank of Japan is in the process of shifting its monetary policy position. It wrong-footed markets in December by widening its yield curve control band. This allowed Japanese bond yields to rise and reversed the long-running slide in the currency.
A new central bank governor and a new plan for the Bank of Japan
The incoming Bank of Japan governor, Kazuo Ueda, has said he is looking for an exit from quantitative easing (QE). The Central Bank is providing a new loan facility to commercial banks which they can use to buy Japanese Government Bonds (JBGs). The aim is to encourage commercial banks to buy more JGBs. These actions could leave room for further appreciation in the yen against the US dollar by smoothing out volatility in the JGB market.
While currency gains would help improve returns for international investors holding Japanese assets, there are other factors that make the Japanese market less appealing. For example, Japanese companies offer far less aggregate earnings growth than their European peers - 3% versus 9%3.
Equally, while it has been argued that the reopening of China should benefit Japan, thanks to its geographic proximity, the early signs show it’s been far more beneficial for Europe. Since China has announced its reopening, European stock markets have outpaced Japanese markets3.
The recent success of European markets may be attributable to the more ‘value’ flavour of European markets. Looking more closely at the MSCI Index, the weights in value sectors such as energy, materials and industrials is 53% in the Europe ex UK Index versus 39% in Japanese stock markets. Japan has more exposure to growth areas, which may be sensitive to rising interest rates. These areas have struggled with performance over the past 12 months, whether they are in Japan, Europe, the UK or the US.
Japan may retain some appeal in today’s market environment. The catalyst could be the Bank of Japan changing its policy to move away from QE. That could encourage more money to flow back into Japan to take advantage of higher interest rates and returns. International asset allocators remain lightly positioned to Japanese equities and it would only take a relatively small shift to move the dial on the market. There is a lot of money in motion today, given the reappraisal of US equities, and some of it may find its way to Japanese markets.
Encouraging the Japanese to invest
The Japanese Government is also taking steps to encourage more domestic investment in Japanese financial assets. The country has high inflation, and its demographics are poor. Encouraging stock market investment to provide a source of income could help address these problems. As part of this, the Government is pushing firms to return capital to investors by increasing share buybacks and raising dividends. Firms are responding and dividend growth is improving. This may also help the market in the year ahead.
It is also worth considering that Japan’s markets have proved relatively stable, while Europe’s were more volatile. The invasion of Ukraine and febrile energy markets have been major contributors, but they may not have the same impact in future. At the same time, inflation in Japan is much lower than levels in western economies, which means the Bank of Japan has an easier job in curbing inflationary pressures.
We believe Japan has a place in portfolios, but some of the problems that have held it back historically remain. In particular, the relatively weak earnings growth of Japanese companies is a concern. There will be tailwinds from any shift in monetary policy, but longer-term growth may be harder to come by. On balance, the issues surrounding Japanese equities may not be behind it.
1 Equity fund flows fall to weakest in eight years, Investment Week, 5 January 2023
2 US Dollar to Japanese Yen Exchange Rate Chart, USD to JPY 2yr view, Xe.com, [accessed 9 March 2023]
3 Refinitiv/ Evelyn Partners
By necessity, this briefing can only provide a short overview and it is essential to seek professional advice before applying the contents of this article. This briefing does not constitute advice nor a recommendation relating to the acquisition or disposal of investments. Details correct at time of writing.
The value of an investment may go down as well as up and you may get back less than you originally invested.
Past performance is not a guide to future performance.