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Podcasts from Confluence Investment Management LLC, featuring the periodic Confluence of Ideas series, as well as two bi-weekly series: the Asset Allocation Bi-Weekly and the Bi-Weekly Geopolitical Report (new episodes posted on alternating Mondays).
Welcome to the Confluence Investment Management biweekly geopolitical report for April 8, 2024. I'm Phil Ambler. The Japanese Nikkei 225 stock index was among the best performing in the world in 2023 and recently reached an all time high. Confluence associate market strategist Thomas Wash joins us today to discuss the reasons for the surge and whether there's room to grow from here. Thomas, the rally is impressive, but it comes after many years of significant underperformance for the Japanese market.
Phil Adler:How long has it been since we've seen a rally like this in Japan?
Thomas Wash:Hi, Phil. Yes. The previous peak of Japan's stock market in 1989 was unique as it wasn't just about the market itself. It coincided with a period of remarkable economic strength for Japan. This strength was evident in several ways.
Thomas Wash:The Honda Accord's dominance as the best selling car in the US symbolizes Japan's manufacturing prowess and growing global influence. The surge in exports contributed to an overheating economy, prompting the Bank of Japan to raise interest rates from 2 and a half percent to 6% as it looked to curtail inflation.
Phil Adler:I remember very well back in the 1980s . The Japanese economy and the markets were so strong that it it almost seemed as if America was developing an inferiority complex. Japan had us beat. Then it all changed. What happened?
Thomas Wash:These concerns raised by US businessmen regarding unfair competition from Japanese companies prompted the US government to take action. In response, the US government pressured Japan to implement certain policies aimed at creating a more level playing field. These policies included measures such as strengthening the Japanese currencies and imposing export quotas on certain goods. These actions were intended to address the perceived advantages enjoyed by Japanese companies and to ensure that American firms had a fair opportunity to expand their market share.
Phil Adler:After that period of prosperity, there have been decades of slow or no growth in Japan until now. Why has it taken so long for Japanese markets to revive?
Thomas Wash:Several factors eroded investor confidence in the growth potential of Japanese companies. First, the economy stagnated for an extended period, raising red flags about the future profitability and such . Second, a looming demographic crisis loomed with an aging population and declining birth rates, shrinking both the workforce and the potential consumer base. Finally, weak consumer spending habits added fuel to the fire. Reluctant consumers led to subdued domestic demand casting doubt on company's ability to achieve strong sales and revenue growth in the future.
Phil Adler:Thomas, to what extent is the Bank of Japan responsible for the recent stock market rally?
Thomas Wash:The Japanese market rally on investor confidence that the country had finally overcome stagnation and achieved sustainable inflation. Now prices remain above the central bank's target of 2% even without policy tightening. Additionally, investors appear to be shifting capital away from China and toward other Asian markets, including Japan. Corporate governance reforms have also played a role in this change.
Phil Adler:I've noticed capital management is cited as another reason for the rally. Japanese companies have become more shareholder friendly. What has changed exactly?
Thomas Wash:Japan has historically struggled to foster a strong shareholder centric environment. To address this, the Tokyo Stock Exchange Group implemented new listing requirements. A key change involves companies trading below a price to book ratio of 1. These firms must now either comply with restructuring rules or provide a clear explanation of their future plans to retain their listing.
Phil Adler:Thomas, can you explain a bit more what role has geopolitics played in the recent trend?
Thomas Wash:The global race for AI dominance have driven China to shore up its domestic semiconductor industry, leading to increased reliance on chip making equipment from Japan. Meanwhile, the United States, Japan, South Korea, and Taiwan have emerged as the big four collaborating to establish an ecosystem conducive of creating and advancing innovative chip technologies. This collaboration is poised to rejuvenate Japan's chip making sector which was once a dominance force in the sector.
Phil Adler:As we look to the future, it's apparent that the Japanese stock market has lately performed much better than the Japanese economy, which recently entered recession. Is foreign investment the major reason for the stock market improvement in Japan?
Thomas Wash:Yes. In anticipation of the Bank of Japan's first monetary policy tightening in 17 years, foreign investment in Japanese stocks surged to multiyear highs. Large cap companies attracted significant inflows as their financial strength allows them to weather higher borrowing costs, rising wages, and potential economic downturns.
Phil Adler:Thomas, can the Japanese stock market continue to grow if the economy in Japan lags?
Thomas Wash:Well, the impact of Japan's recent economic trouble hinges on its severity and duration. While the initial GDP estimate suggested that the country technically enter a recession toward the end of 2023 with two consecutive quarters of negative growth, a positive revision to the last quarter's data suggests a narrow escape. One reason the Japanese stock market has held up relatively well is because of a large portion of investment is in established companies. These larger firms tend to be more resilient during economic downturns due to their financial strength and diverse portfolios. Additionally, there's some optimism that the slowdown may be short lived.
Phil Adler:Thomas, what about consumer confidence? What's the level right now in Japan, and how much does consumer confidence influence the economy there?
Thomas Wash:While consumer confidence has shown signs of recovery in recent months, a disconnect remains. Household spending continues to lag, falling 6% year over year, which highlights lingering consumer caution. This cautiousness is further amplified by the recent rise in unemployment, suggesting a potential slowdown in the job market.
Phil Adler:Do negative demographics that you've already mentioned continue to be a roadblock for the Japanese economy?
Thomas Wash:While demographic trends can paint a concerning picture of Japan's workforce, a more insightful metric for economic activity might be the labor force participation rate, particularly for women. While demographic trends contain a concerning picture of Japan's work force, a more insightful metric for economic activity might be the labor force participation rate, particularly for women. Traditionally, Japan's male dominated workforce limited its overall potential. However, recent reforms are encouraging greater female participation, unlocking a significant talent pool. This shift is already showing positive results.
Thomas Wash:The female labor participation rate has risen from 47% in 2013 to 53% in 2022, a promising trend for economic growth.
Phil Adler:Thomas, just a couple of more questions. Economists at Confluence have noted that foreign stock performance is heavily influenced by the value of the US dollar. When the greenback is appreciating, foreign stocks typically struggle and vice versa. Right now, the greenback is strong. The yen is very weak, and yet Japanese stocks have been rising.
Phil Adler:What's the explanation?
Thomas Wash:The Bank of Japan's reluctance to aggressively tighten has contributed to the recent market rally. This approach is likely to maintain favorable borrowing conditions for businesses and consumers, potentially fueling further economic expansion. Additionally, the bank's willingness to intervene in currency markets could help cushion a blow of a strengthening dollar.
Phil Adler:Thomas, you mentioned the strength of large cap stocks. Major Japanese stock indices are also tech heavy, which might explain part of the recent advance. Must the rally broaden out for it to continue?
Thomas Wash:Well, not necessarily. As we've discussed earlier, Japanese equities have only recently surged in popularity. This suggests there could be more upside before a peak. However, let's not overlook Japan's strong auto industry, which has also shown recent positive momentum.
Phil Adler:To sum up, what major challenges lie ahead for the Japanese market?
Thomas Wash:Well, foremost, economic growth remains a key concern. While the recent upward revision to GDP was positive, there are still no signs of a sustained strengthening trend. Additionally, slowing inflation warrants attention as it could indicate weaker pricing power for companies than previously thought over the past few years.
Phil Adler:Thomas, what's the advice from Confluence for investors?
Thomas Wash:This report highlights the Indo Pacific region as a compelling diversification option for investors seeking exposure beyond the US. While Japan presents attractive opportunities, countries like India and South Korea also hold promise.
Phil Adler:Thank you, Thomas. Time to tell our listeners that this discussion is based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice. This information does not constitute a solicitation or an offer to buy or sell any security. Our audio engineer is Dane Stone.
Phil Adler:I'm Phil Adler.