Originally, interest rates were lowered to zero in order to escape deflation and economic weakness. However, history has shown that this did not succeed despite the interest rate policy and all the economic stimulus programs. However, when interest rates were raised in the western hemisphere, the Japanese currency began a massive slide, which, together with the spikes in inflation that have persisted since the coronavirus pandemic, also pushed inflation in Japan to unprecedented levels and has now set in motion the price-wage spiral “longed for” by the central bank for the first time. You could also say that after the carrot of cheap money did not work in Japan, the stick of inflation and yen devaluation is now coming, which seems to be working better.
Historic high reached again after 34 years
It took the Japanese Nikkei share index a whole 34 years to reach its old high again after the highs of the 1990s. In the 1980s, Japan experienced an unparalleled boom with the export of low-cost high technology, consumer goods and cars to the western world. This all culminated in Japan's self-imposed restriction on car exports in 1981. Last but not least, the cheap yen contributed to the success of exports, which led to the Plaza Agreement in 1985 (the US dollar was to depreciate against the German mark and yen in a controlled manner). The yen then appreciated massively. Even more money flowed into Japanese equities and real estate, and the boom culminated in the highs of 1990. We have already seen a reversal in the trend of the yen recently, especially due to the communicated efforts of the Bank of Japan (BOJ) to normalize the interest rate markets in Japan. Interest in the Japanese real estate market has increased since then.
Holding capital is no longer worthwhile
But what has supported the stock market so far and are these aspects long-term pillars for a stable upward trend? The Japanese stock exchange operator Japan Exchange Group (JPX) is massively pushing for corporate reform in order to improve the quality of the Japanese stock market. This effort alone would not have been enough to set the market in motion. Together with the impetus from inflation, however, the reform agenda is gaining significantly more momentum. As inflation rates rise, so do refinancing costs. The tolerance for holding on to cash positions, excess capital and low-margin business areas is dwindling, as all these business practices are hardly worthwhile or even destroy value in an inflationary environment. A major structural factor in the Japanese labor market is the supply deficit of workers as the Japanese population ages and shrinks. For this reason, the wage inflation that is now beginning is likely to remain a driving factor in the long term.
Focus on efficiency
Wage increases will also become part of the growth model; job platforms, among others, can benefit from this. In line with this, the number of company bankruptcies is rising steadily due to an increasingly absent workforce: while there were only 35 in the first half of 2014, the number rose to 182 in the first half of 2024. This is leading to a focus on efficiency and value creation and a concentration on areas in which there are strengths. Furthermore, the aspect of rising wage costs will contribute to an urgently overdue digitalization in Japan, as the productivity of Japanese workers has been stagnating for around 25 years.
Japanese companies are expanding their domestic capacities
The driving mechanism of the past 30 years - cutting costs in order to keep prices and wages low - now seems to be reversing. The crisis factors of the 1990s, with overcapacity in personnel, factories and debt, caused a long-lasting deflation, which 30 years later - after reorganization and restructuring - led to balance sheets with above-average levels of cash and cash equivalents. The trends that have now begun should help to actively deploy the cash positions that many Japanese companies have accumulated. Investments in digitalization, but also in local production, are a good way to do this. The Development Bank of Japan recently surveyed internationally active Japanese companies about their investment plans in Japan. Around 50% of companies stated their intention to expand their capacities in Japan over the next three years. In 2019, the figure was only around 35%.
The push reversal from deflation to inflation leads to share buybacks
The Japanese stock exchange operator JPX plays a central role in the revitalization of the local stock market. In 2014, JPX published a Stewardship Code and in 2015 a Corporate Governance Code, which advocated the reduction of cross-shareholdings, which are very popular in Japan, and have already contributed to their significant reduction. This was supplemented last year with the “efficiency reform”, which specifically aims to improve the price-to-book ratio and capital efficiency. Together with the reversal from deflation to inflation, this strategic plan has had a strong impact and has helped the Japanese stock market to make an impressive recovery. Japanese companies need to adjust to an inflationary environment. This is good for, among other things, price increases at retail and consumer goods companies, which implemented their first price increase in 14 years on October 1, 2024. The Japanese stock exchange operator supports this institutionally, under threat of concrete consequences (e.g. delisting). This phenomenon is also evident in the massive increase in share buybacks (most recently +72% compared to the previous year). This measure is probably the fastest-acting means of increasing the capital efficiency of overcapitalized companies.
Class instead of mass
Further reforms are in the starting blocks. With the current reforms, the Japanese TOPIX equity index aims to reduce the number of index members by more than 40% from around 2,100 to around 1,200 in 2028. With the targeted index composition, each index member should have an average daily turnover twice as high and a tradable market capitalization twice as high. The way to achieve this is to significantly improve the return on equity, the margin and the price-to-book ratio. By these standards, Japanese companies have low values in international comparison due to their traditionally above-average liquidity, cross-shareholdings and holding on to unprofitable business units. All the measures initiated here should make the Japanese stock market more attractive. The growing interest of the Japanese themselves can also be seen in the significant increase in the number of NISA accounts (tax-advantaged investment option). More than 40% of new investments in NISA accounts flowed into Japanese equities in the first half of the year. The asset allocation of the Japanese still leaves significant scope for investment here, with around 51% in cash and savings, compared with only 13% in the USA and around 36% in Europe. It is interesting to note that young Japanese in particular have a high proportion here - those who did not experience the crash of the 1990s.
Rising interest rates hold potential for the financial sector
On July 31, 2024, the BOJ raised interest rates for the second time from a range of 0% to 0.1% to 0.25%. It also explained that it aims to raise interest rates further if economic development and price trends are in line with its outlook. It also announced that it would reduce its purchases of Japanese bonds by 400 billion yen per quarter - it will thus de facto remain in “easing mode”, but will enable a gradual increase in the longer end of the yield curve through lower demand.
The BOJ has thus laid the foundation for the banking sector to benefit from higher interest rate premiums, higher short-term key interest rates, higher yields on Japanese government bonds (JGBs) and an increase in overnight interest rates (TIBOR). As in Europe and the USA before, this will allow banks to return to a “normal” operating environment with profitability in line with the sector. This also puts them directly on the politically desired path of improving profitability and the price-to-book ratio. As described above, net interest income is derived from different sources and different maturities of the yield curve. In the medium term, it seems realistic to assume an increase at both the short and the long end of the yield curve. For a model calculation with an interest rate of 0.25% in overnight trading, 0.50% for 2-year JGBs and 1.20% for 10-year JGBs, this results in an upside potential in net interest income of 20 to 30% for the major Japanese banks in the medium term.
In the short term, the Japanese market may be volatile due to exchange rate fluctuations. Structurally, however, a change in direction has been initiated, particularly for the financial sector (13% share in the TOPIX index), which should hold further potential in the medium term.
Source picture: Adobe Stock, AI generated
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