The Nikkei 225 just passed its record high reached 34 years ago, despite the Japanese economy being in recession. RBC Wealth Management explores the factors behind investors’ enthusiasm and explains why the macroeconomic backdrop is not a deterrent, and suggests how investors should position their portfolios.

Several factors have conspired to attract investors’ attention to Japanese equities, according to RBC Wealth Management.

Having endured bouts of deflation in the past two decades, inflation made a welcome return after the Covid-19 pandemic, RBC WM said in note: “This heralded a sea change in corporate behaviour, enabling companies to increase prices and suggest profitability could improve.” 

The Tokyo Stock Exchange introduced important corporate reforms last year after the government shamed the corporate sector for its notoriously low returns and demanded change. By divulging company names and using peer pressure, RBC expects the Tokyo Stock Exchange will encourage more companies to announce plans to improve shareholder returns. The results of the reform are already apparent, in RBC’s view.

The Japanese government also recently revamped the Nippon Individual Savings Account (NISA), a tax-free stock investment programme for individuals, by expanding annual investment limits and granting indefinite tax-exemption periods. Given that as of September 2023, 52.5 per cent of Japanese households’ financial assets were held in cash – almost twice the size of Japan's GDP – the new NISA could drive domestic retail demand for stocks.

RBC believes that in a world of increased geopolitical tensions, Japan may be seen as a proxy for investing in China.

The Tokyo Stock Exchange reforms are an attempt to shake up a corporate sector suffering from a disappointing domestic economy, in RBC’s view. While Japan’s economy finished 2023 on a subdued note, RBC thinks there are reasons to believe the outlook will stabilise. Monthly trade data and economic indicators suggest that business conditions across all industries were the strongest in five years. Meanwhile, Japan also benefits from the friendshoring and reshoring trends, RBC said. Positive real wage growth should also help consumption recover. This spring’s shunt? annual wage negotiations, during which thousands of unions will simultaneously negotiate wage agreements with employers, are key to watch, in RBC’s view.

According to RBC, the Bank of Japan has been hesitant to tame above-target inflation by ending its long-held negative interest rate policy for fear of knocking its already subdued economy further off course. Yet, maintaining a loose monetary policy is markedly weakening the yen, contributing to inflation. The BoJ is thus mulling over its first-rate hike in 16 years. Markets are priced for a 0.1 per cent rate hike by June and a full 0.25 per cent by year end. Such careful moves are unlikely to throw the economy off course. And with other central banks cutting rates this year, the interest rate differential with Japan will diminish, in RBC’s opinion, alleviating the pressure on the yen.

RBC said it maintains its overweight position in Japanese equities. It prefers consumer sectors as higher real wages should encourage consumption, selective stocks in the financial sector (slightly higher interest rates should help profitability), and high dividend stocks that could benefit by retail fund flows under the new tax-efficient investment scheme. Other wealth managers are also positive about investing in Japanese equities. Jeremy Osborne, head of Japan equity investment directing at Fidelity International, thinks Japanese equities still offer compelling value and investors are underexposed to the market. See more commentary here.