Japan's stock market in a rally reminiscent of its 90's glory

The last time Japan's stock market was in the news under similar circumstances was a few decades ago when I was fervently trying to rescue a two-dimensional Princess Peach from Bowser's claws in a heavily pixellated Super Mario version we now revere as vintage.

Japan's stock market has risen to a 33-year high and hit a new peak just yesterday, buoyed by a wave of corporate buybacks and strong corporate earnings, and pumped up by a weak yen.

Thus far in 2023, the Japanese stock market has outperformed all major markets with the exception of the tech-focused Nasdaq. The Nikkei, representing the top 225 companies traded on the Tokyo Stock Exchange, is up more than 15 per cent this year – or 11 per cent in dollar terms, as against a 7 per cent gain for world stocks.

Since global stock prices crashed in mid-March, the Topix, the Tokyo stock price index, has gained 8.5 per cent, making it the best-performing among major markets. By contrast, the S&P 500 gained 5.6 per cent, whilst the MSCI Asia Pacific index gained 3.4 per cent in the same time span.

A number of factors, not least of all the endorsement of billionaire investor Warren Buffett, have contributed.

At the annual shareholder meeting of Berkshire Hathaway, Buffett's multinational holding company, he revealed that the company had invested in five Japanese "sogo shosha" or trading houses on 30 August 2020.

The initial investment amounted to just over 5 per cent of Itochu, Marubeni, Mitsui, Mitsubishi and Sumitomo. Berkshire Hathaway has now raised its stakes to around 7.4 per cent across the board.

Buffett's investment swelled from USD 6 billion (GBP 4.8 billion) to USD 15 billion (GBP 12.1 billion) in under three years.

He described the companies' valuations as "ridiculous" relative to the prevailing low-interest rates.

Corporate reforms within Japan that have led to increased shareholder returns, as well as unfavourable conditions in other global markets, have contributed to the boon, with fund managers saying the interest in Japanese stocks is at its highest level in a decade.

Not everyone is as upbeat as Buffett, however.

After decades of insipid growth and very low inflation, a period of higher growth, and with it, higher inflation, has arrived in Japan. The pressure is on the Bank of Japan's new governor, Kazuo Ueda, to now navigate the journey back to normality.

Whilst Ueda has not revealed his hand quite yet, the uncertainty is giving rise to speculation. Markets expect the yen's precipitous decline from last year to reverse course if policy positions change.

This would hurt Japan's export-oriented economy.

Unlike other major economies, the country maintained a low benchmark rate even during the pandemic. This led to a weakening of the yen, boosting Japanese exports.

"(A stronger yen) will hurt outwardly focused large conglomerates who will face an unfavourable domestic exchange rate, higher onshore borrowing costs and are also exposed to a weakening global economy," said Aninda Mitra, head of Asia macro and investment strategy at BNY Mellon Investment Management.

However, Mitra is more upbeat on banks and smaller companies.

Some foreign investors and advisors alike are still reluctant to venture into the market, recalling previous occasions when initial euphoria fizzled out.

The research arm of BlackRock, the largest asset manager in the world, is sticking to a recommendation of "underweight" allocation to Japanese stocks for now.

The policy uncertainty only serves to amplify the risk for some.

Ben Powell, Asia-Pacific chief investment strategist at BlackRock Investment Insitute said: "I'm old enough to remember the excitement of Abe introducing the 'three arrows'," – a reference to former Prime Minister Shinzo Abe's economic reforms of a decade ago aimed at reviving growth.

"A very significant inflow from global investors (followed)," Powell said, "but then unfortunately, a lot of the enthusiasm has dissipated."

By contrast, the Japan Times pointed towards cause for optimism, noting that Topix firms are forecasting operating profits to rise about 6 per cent in the fiscal year ending March 2024 - solid if not spectacular. The outlet further noted that historically, companies on the exchange tend to be conservative.

In addition, the underlying performance of Japanese companies seems robust.

"Earnings seem pretty good, with the important auto sector expecting profit growth," said Takashi Hiroki, chief strategist at Monex, Japan's third-largest online broker.

"Domestic demand-oriented companies are benefiting from the prospects of an increase in inbound tourism, while big banks also had bumper earnings."

Hiroki expects further gains of 10 per cent or more by the end of the year.

Furthermore, even at its momentous 33-year high, the Nikkei is hardly looking expensive, given a price-to-book ratio of 1.3 times, compared with 4 for the S&P 500 Index and 1.8 for the Stoxx Europe 600. Cheap valuation is the key reason why Nicholas Smith, a strategist at CLSA, is also predicting a further rally of at least 10 per cent.

Korean retailer investors are amongst those giving the Japanese stock market their vote of confidence.

Data from the Korea Securities Depository (KSD) showed that Korean investors purchased $46.5 million (6.12 billion won) worth of Japanese shares between 18 April and 19 May.

This is an abrupt turnaround from the lukewarm performance of Japan's main stock index, the Nikkei 225, a month earlier.

An example of Korean enthusiasm is the large amount of investment attracted by Nintendo, a Japanese gaming company, possibly due to its familiarity among Korean investors.

Shares in Nintendo rose more than 10 per cent in the past month on the back of the box office success of "Super Mario Bros. Movie", an animated film based on Nintendo's Mario video game franchise.

With plenty of experts advising caution, there are nevertheless many that point to the strong underlying performance of Japanese firms - the latter believe these underlying gains will be able to weather any policy changes such as interest rate hikes.

Whilst the Japanese stock market rally continues to remind the world of a time when the Sony Walkman was the height of teenage sophistication, both camps are waiting to see what Kazuo Ueda's next move will be.