Will Japanese Equities Outperform Global Equities in US Dollars?

No, we do not expect Japanese mid-/large-cap equities to outperform their global peers despite some supportive factors, such as Tokyo Stock Exchange (TSE) reforms and inflows from security investment schemes. Japanese equities tend to underperform in global activity slowdowns and contractions, and current valuations do not offer sufficient compensation to bear that risk, given our macro views. In addition, we expect the yen to continue strengthening—which should be an earnings headwind—while volatility may also be elevated around the upcoming general election. Instead, we recommend holding Japanese equities in line with benchmark weights.

In local currency terms, Japanese equities have enjoyed strong performance since early 2022. Between January 2022 and April 2024, Japanese equities outperformed global equities by a cumulative 33.7%. Hedging yen exposure back to dollars delivered even better returns for non-Japanese investors due to the large interest rate differential, with the outperformance over the same period amounting to 52.6%. However, one of the defining characteristics of this entire period was a sharply depreciating Japanese yen. Once this dynamic stalled earlier this year, and then started to reverse, so did relative performance, with hedged Japanese equities underperforming by 13% since April. We believe the yen will continue to strengthen and, therefore, will present an ongoing challenge to the performance of hedged Japanese equities.

Central bank divergence looks likely to drive a recovery for the yen in the coming quarters, just as it caused the weakening of the currency in recent years. During the current monetary cycle, the divergence between the interest rate policy of the Bank of Japan (BOJ) and the US Federal Reserve was particularly stark. The BOJ maintained negative interest rates for several months after the Fed had reached their peak rate of between 5.25% and 5.5%. Now, the BOJ policy rate has reached the modest, though positive, level of 0.25%, and the Fed has cut rates by 0.5 percentage points. However, with inflation in Japan running consistently above target and real wage growth now positive, the BOJ looks able to gradually deliver further rate rises, while the Fed will also continue its cutting cycle. Bigger picture, the yen’s real effective exchange rate stands more than 30% below its median. There has generally been a positive relationship between the long-term direction of the yen and the relative performance of Japanese equities in dollars, but the relationship has flipped on a shorter horizon. We see risks that this negative correlation could persist, given the headwind to earnings that a stronger yen represents.

Japanese equities tend to underperform their global peers in global economic slowdowns and contractions. This is due to the cyclical exposure of the market, which has large overweights to industrials and consumer discretionary. We broadly expect growth to be close to trend, but remain sensitive to downside risks, particularly in light of weak activity data in China and Germany and some evidence of a cooling US labor market. What’s more, the recently announced election in Japan may also contribute to increased volatility in the domestic market. In our view, current Japanese valuations don’t offer sufficient compensation for these risks. Our preferred CAPCE valuation measure shows Japanese equities trading at the 77th percentile of their own history, and at the 24th percentile versus global peers. While the latter is somewhat attractive, it is in part attributable to the sector tilts of the Japanese market. Although the valuation appeal is improving, it’s lessened when adjusted for sectoral composition and relative profitability.

There are factors that may prove to be tailwinds for Japanese equities. One is the expanded NISA (Nippon Investment Savings Account) scheme, which allows Japanese households to invest free of income and capital gains tax. The expanded allowances should see a greater flow of household funds being invested in domestic equities. The TSE corporate reform agenda may also offer some further support. These reforms aim to increase shareholder value by encouraging companies to use or return excess cash and place greater emphasis on their cost of capital, amongst other things. Engagement of large companies with the reforms is elevated, with scope for further uptake among smaller firms.

All told, while Japanese mid-/large-cap equities have some points of attraction currently, we recommend holding them in line with benchmark weights. Small-cap Japanese equities look well placed to exhibit greater resilience, given a lower foreign revenue exposure and more scope to benefit from further progress on TSE reforms. As such, this forms a support to our developed markets ex US small-cap overweight.

Thomas O’Mahony, Senior Investment Director, Capital Markets Research