Japan’s Structural Awakening

Naomi Fink

Japan is experiencing an awakening, offering attractive long-term valuations amid a changing landscape.

It is tempting to attribute Japan’s resilience to its low-growth, low interest rate environment, while other developed economies, like the U.S., face inflation, job losses, and rising borrowing costs. However, Japan has not been frozen in time during its thirty years of deflationary low growth. The aging demographics that once suppressed demand are now driving labor shortages, pushing more people into the workforce and forcing companies to raise wages. As of June 2024, consumers have regained purchasing power through positive real wage growth, with second-quarter GDP growth largely fueled by rising household consumption and private investment.

These surprises may challenge the notion that Japan is still trapped in deflationary zero-growth dynamic and that the recent upturn is merely a short-term gain driven by a weak yen and undervalued stock market. The Japanese domestic equity market has recovered from steep sell-offs reminiscent of Black Monday, historically marking the decline of Japan’s nominal growth and domestic participation thirty years ago.

Market volatility tends to cluster, which means nervousness may result in new dives and subsequent rebounds.  In these swings, however, we foresee an opportunity in three parts which are:

• Semiconductors;
• Small to midsize firms;
• Domestic-demand related sectors.

Semiconductors. The equity market’s current fixation with U.S. large-cap technology stocks may make this sector the most obvious pick; indeed, it is one that has attracted plenty of capital from overseas investors seeking to deploy their cheap yen in positive-yielding assets. The sector, of course, also experienced an aggressive correction in valuation as the “carry trade” unwound and liquidity was withdrawn from other sectors it had most favored during the current investment cycle. The semiconductor sector also happens to be sensitive to overseas revenues and therefore a stronger yen. We also note that the carry-trade-related sell-off created attractive levels for entry, allowing investors the opportunity to gain exposure to a popular investment sector at better levels, in an environment where natural buyers abound. Large companies are buying back their shares in efforts to increase the attractiveness of their balance sheet to shareholders; meanwhile long-horizon investors are building up their Japanese equity holdings after long being under-weight. The sector, no doubt, remains highly attuned to sentiment over global growth, which is likely to make it prone to future valuation dips (which we hold will create buying opportunities).

Of cyclical sectors, semiconductors are likelier than most to offer structural value given their pivotal role in digital infrastructure not limited to AI, key ingredients to technological solutions likely to help Japanese companies retain – or even expand – their margins amid the structural labor shortage. We continue to draw attention to the causal link between structural labor shortages and investment by firms in labor-intensive sectors, particularly increased capital expenditure in software offerings that also represent increases in the semiconductor sector’s revenues. Also supportive is the strategic priority placed by the government (which has directly put money to work to build facilities in the sector) upon Japan’s digital transformation even in the absence of a broader fiscal-expansion bias.

Small-to-mid cap stocks. Structural reform among Japan’s corporations is making itself apparent in the transformation of many companies’ balance sheets. As the Tokyo Stock Exchange has put pressure on listed firms to disclose medium-term investment plans and find better uses for balance sheet cash (which overall totals in excess of JPY350trn, $2.27 trillion), many companies have increased shareholder payouts (including buybacks, mechanically increasing return on equity) as well as capital investments (designed to secure future cash flow by boosting productivity and competitiveness.)

Meanwhile, although valuations have adjusted most notably higher among large-cap stocks of companies well-recognized by overseas investors, there are plenty of firms that have not yet reaped the valuation benefits of reallocating cash. Indeed, almost half the firms listed on the Tokyo Stock Exchange’s TOPIX Index are priced below book value, which suggests that there are still compelling investment theses in lesser-known, smaller-cap firms that have plans to deploy their cash balances to raise return on equity via equity buy-backs, to prime for buyouts or to improve future productivity via transformative capital investments. That said, a small to mid cap stock with large cash balances is not in itself an investment thesis. Active strategies designed to distinguish firms with transformative medium-term investment plans (whether in physical or human capital) or other uses of return-boosting potential is likely a necessary overlay. Alpha lies in wait for those capable of skillfully selecting such firms.

Rotation to domestic demand. Global investors have shown little enthusiasm for smaller,  domestic-demand driven firms in Japan, favoring instead large-cap stocks with global revenues. Many of these smaller firms are net importers, disadvantaged by yen weakness and rising import costs. While domestic sectors have benefitted indirectly from the yen’s decline, their performance still lags behind exporters. Investor skepticism stems from uncertainty over U.S. growth, which could negatively affect large exporters. However, smaller, domestically oriented firms may not share the same fate.

Recent indicators, including rising private demand and real wage growth, suggest a shift is underway. Domestic demand is gaining momentum, driven by skilled labor shortages, rising wages, and increased expectations for future income growth. This shift may prompt households to move away from holding zero-yielding cash deposits and instead favor consumption or investment in positive-yielding assets. The growing uptake of tax-free savings under the “new NISA” individual tax-free investment account supports this trend. While Japan’s stocks may soften with U.S. growth fluctuations, domestic demand offers potential portfolio diversification, insulating against U.S. market cycles. Given the limited diversifiers available against U.S. market risk, Japan’s home market could provide valuable mid-term diversification.

With a shifting economic landscape driven by rising wages, labor shortages, and increasing private consumption, sectors like semiconductors, small-to-mid cap firms, and domestic-demand industries are positioned for well for sustained growth. While global market cycles and external factors will continue to influence Japan’s economy, the evolving dynamics of its domestic market offer a unique chance for portfolio diversification and sustainable returns, making it an attractive option for investors in today’s uncertain environment.

Naomi Fink is Nikko Asset Management’s Chief Global Strategist.

This feature is to provide general information only, does not constitute legal or tax advice, and cannot be used or substituted for legal or tax advice. Any opinions of the author do not necessarily reflect the stance of ISS STOXX or its affiliates.