Where Japanese stocks go from here

Few markets demonstrate the patience, and sheer risk of missed opportunities, that come with investing quite like Japan. It wasn't until early 2024 that the Nikkei 225, one of the widely followed indices in the country, broke a fresh all-time high, ending a 34-year wait. That reflects a bubble that took hold in the 1980s and many bouts of underwhelming performance since, although Japanese equities have certainly been on a tear more recently.

Investors have had to show their mettle, however, with Japanese shares tumbling briefly in August thanks to the unwinding of the yen carry trade. It's worth considering what opportunities might remain for investors, though. As has long been the case, investing in Japan can have something of a macroeconomic flavour.

External factors tend to unavoidably play a big role in how Japanese equities fare. 7IM's Ben Kumar puts it bluntly, noting: "At the moment, the correlation between the equity market and the yen is so strong that it almost makes sector or stockpicking irrelevant. If the yen is weakening, the Topix will be up and vice versa."

With that in mind, it's worth considering the trajectory of the Japanese currency, which has weakened notably versus the likes of the US dollar since the start of 2023. Japan has recently undertaken some monetary policy actions that normally tend to strengthen a currency, including raising interest rates for the first time in many years, but other developments, including the unwinding of the yen carry trade, have kept it weak.

As Capital Economics put it, recent weakness might relate to continued uncertainty about the future path of interest rates, especially ahead of elections last month. "Bank of Japan (BoJ) policymakers have seemed in no rush to tighten monetary policy further at their last meeting in late September, leading us to push back our forecast for a final rate hike to December," Capital Economics said in late October.

However, the research house expects the currency to rebound before long, noting: "We expect interest rate differentials to shift back against the US dollar, as we think investors have now gone a bit too far in pricing out rate cuts from the Fed. 

"Meanwhile, a 25 basis point rate hike from the BoJ is not fully priced into markets until the middle of next year, so such a move this December – which we doubt the next government will try to prevent – could provide some support to the yen."

Capital Economics adds that the currency has looked fairly lowly valued, with its real effective exchange rate coming in at about 15 per cent below its five-year average. As such, it could appreciate notably by the end of 2025.

Past the macro

If the yen does both strengthen and maintain an inverse correlation with Japanese equities, returns could be lower at least in yen terms. But a stronger yen does translate into greater sterling returns for the UK investor, offsetting some of the potential pain.

It isn't all doom, however. Japanese shares have had a fierce run in the past couple of years but are still coming up from the lows of the past few decades. What's more, the usual case for investing here remains. Namely, that the corporate reforms initiated by the late Shinzo Abe are still feeding through into the system, with Japanese companies more likely to carry out shareholder-friendly actions such as paying dividends or doing share buybacks.

It should be acknowledged that the yields on offer from going Japanese are still low compared with the likes of UK or Asian equity income: the average yield in the AIC's Japan sector comes to 1.6 per cent, with the highest on offer standing at 3 per cent. However, this is still not to be sniffed at, while the argument holds that said dividends have good scope to grow over time.

Where should investors focus if they want to make the most of such structural trends? A good number of funds now focus on cash-rich companies lower down the market cap spectrum, which can be encouraged to carry out shareholder-friendly actions. But even looking past this very broad trend, there are sectors that could prosper in the longer term.

Putting aside his views about the yen's inverse correlation to markets as of late, Kumar believes that two sectors could offer decent returns.

He firstly points to Japanese banks, noting: "If they can stay in business after three decades of zero interest rates, they should be in a really strong position to make money even if rates only rise a little bit."

Kumar also sees healthcare as a promising sector thanks to Japan's ageing population.

"If you want a test case country for the healthcare issues of the future, with the exception of obesity, Japan is ideal," he says.

"The rest of the world is aging towards where Japan is today. If a company can be successful in Japan, whether that’s age-targeted drugs, or robotic assistance, or care home provision, it has decades of potential international growth ahead of it."

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