- At the July meeting, the Bank of Japan (BOJ) raised the cap on 10-year yields to 1.0% from 0.5%.
- The BOJ’s yield curve control (YCC) has come under pressure since 2022. It caused the weakening of the yen, leading to higher import costs, and consequently boosting corporate and household living expenses that creates pushback from the public.
- Looking ahead, the odds of a policy normalisation have risen. We believe that the recent policy tweak lays the crucial groundwork for the BOJ to eventually abandon the YCC and tighten its monetary policy.
- We see upside for JGB yields and consequently, a yen appreciation. We reckon that the positives associated with a stronger yen should outweigh the negatives for Japanese equities, and could also provide room for the outperformance of value stocks.
- Using a fair PE ratio of 18X, we project a target price of 41,300 for the Nikkei 225 Index by 2025, which translates into an upside potential of 27% as of 10 August 2023. Japan remains as our top equity pick, with a Star Rating of 4 Stars – Very Attractive.
At the July meeting, the Bank of Japan (BOJ) left the target for both its short-term policy rate and the 10-year government bond yield unchanged at -0.1% and 0% respectively. However, it raised the purchase cap on the JGB 10-year bond to a yield of 1.0% from 0.5%, marking the central bank’s first major change since Kazuo Ueda assumed the role of governor in April.
Market reaction to the policy tweak was volatile across asset classes. The 10-year Japanese government bond (JGB) yield rose to its highest level since 2014 (Figure 1). Meanwhile, Japanese equities pulled back slightly, though major indices like the Nikkei 225 and TOPIX remained at a three-decades high (Figure 2). However, the yen saw large swings before slipping to one of the lowest points against the dollar this year at the time of writing.
Figure 1: Yields soared as the BOJ takes on a more flexible approach
Figure 2: Nikkei 225 and TOPIX remain at a three-decade high
Making sense of the YCC
Since 2016, the BOJ has pursued an ultra-easy monetary policy using the yield curve control (YCC) to fight a deflationary environment that lasted three decades. Under the YCC policy, the BOJ seeks to control the Japanese yield curve by fixing short-term rates (at -0.1%) and the 10-year JGB yield (at around 0%), while maintaining a target band for JGB 10-year yields (0% to 1.0%, previously set at 0% to 0.5%). Following the July meeting, the band has now been widened to move within 100 bps of the 0% target.
By artificially keeping policy rates and JGB yields very low, the central bank aims to encourage consumers to spend and businesses to invest, hoping to drive inflation and economic activity.
However, the YCC has come under pressure since 2022 as the fixing of bond yields means that the yen is highly sensitive to interest rate changes overseas. As the interest rates of major economies surged following a wave of rate hikes, the rate differential between the BOJ and global central banks has widened significantly, leading to a weakening of the yen against major currencies (Figure 3).
Figure 3: Yen is the worst-performing G10 currency
This has brought about several negative impacts. In particular, a weaker yen against the dollar results in higher import costs, boosting corporate and household living expenses that creates pushback from the public. Higher goods prices have been driving inflation in Japan, with the core consumer price index (CPI) in June rising 3.3% year-on-year (Figure 4). This exceeded the BOJ’s 2% target for the 15th consecutive month, further challenging the central bank’s ultra-easy monetary policy. In fact, upside risks to inflation was cited as a key reason for the July policy tweak according to BOJ governor Kazuo Ueda.
Figure 4: Japan’s inflation has reached at a decades-high
Increasing likelihood of policy normalisation
Looking ahead, the odds of a policy normalisation have risen. Although the BOJ has rejected the view that it will be exiting from monetary easing measures, we believe that the recent policy tweak lays the crucial groundwork for the BOJ to eventually abandon the YCC and tighten its monetary policy.
As such, we wish to highlight that Japan’s inflation is structurally different compared to other major developed economies such as the US. Inflation in Japan is driven primarily by lingering cost-push pressure from rising import prices. On the other hand, sticky inflation in the US has largely been driven by higher wages as a result of a robust labour market.
The BOJ remarked that “sustainable and stable achievement of 2% inflation target, accompanied by wage increases, has not yet come into sight”, suggesting that it is keeping a close watch on wage data and how their moves could affect the outlook for inflation. It also holds the view that nominal wage growth will need to hit 3% YoY to achieve a 2% inflation target in a sustainable manner. At present, Japan’s nominal wage growth stands at 2.3% YoY as of June, slightly lagging behind the inflation rate.
Figure 5: Keep a close watch on nominal wage growth
As such, the outlook for wages is a key determinant of how quickly the BOJ could move towards dismantling its YCC. A common indicator for future wages in Japan is the shunto – wage negotiations between major corporations and unions that take place annually during spring. Given that the call for stronger wage growth is mounting, the outlook for wages remains positive, with the shunto in FY2024 anticipated to continue delivering robust growth as observed in FY2023 and remain higher compared to long-term historical levels (10Y average: 2.1%).
Figure 6: FY2023 shunto saw a sharp surge
Besides, we think that even if nominal wage growth fails to hit 3%, a pick-up in wage growth, alongside the ongoing recovery in consumption (tourism and domestic recovery), would add to the stickiness of inflation and provide the BOJ with a solid reason to normalise its monetary policy. While the pace of BOJ’s policy normalisation is still uncertain, the bottom line is that we believe Japan is on the verge of a policy shift.
Not all Japanese equities are created equal
The unwinding of YCC would bring about higher JGB yields and consequently, a yen appreciation because of narrowing interest rate differentials between the BOJ and global central banks. While a weaker yen is traditionally beneficial for Japanese equities (largely through the boost in earnings as many companies derive significant revenue overseas), this time is different.
A stronger yen can help to mitigate prevailing macro risks such as persistent trade deficit owing to a strong dollar as well as higher inflation. Besides, the yen appreciation should also renew optimism of foreign investors and lead to higher inflows into Japanese assets. As such, we reckon that the positives associated with a stronger yen should outweigh the negatives for Japanese equities. We think the yen appreciation is likely to be gradual given the BOJ’s cautious approach on easing monetary policy, thus limiting knee-jerk reactions in the Japanese equity markets.
Moreover, in our previous update, we mentioned that an improving domestic consumption and a tourism spending boost should drive a consumption-led growth this year, keeping the Japanese economy resilient. Companies are also well-buffered by the strong cash-rich balance sheet. Over the longer term, growing momentum for corporate reforms and the potential to re-emerge as a semiconductor powerhouse paints a rosy picture for Japanese corporates and the economy. Lastly, in terms of valuations, Japanese equities remain cheap despite the strong rally this year.
(Related article: Japanese equities hit a record high. Here’s why it remains our top equity pick)
Furthermore, the ongoing decade-high inflation and the likely normalisation of monetary policy provides room for the outperformance of value stocks in the medium term. Using the MSCI Japan Value Index, we observe that the Japanese value universe is dominated by companies from the industrials, financials, and consumer discretionary sectors.
Heavyweights in the industrials sector such as Mitsubishi Corp and Hitachi provide an inflation hedge. For Mitsubishi Corp, the largest Japanese trading company and one of the five that Warren Buffet has invested in, the inflation hedge is provided by its sizable exposure to commodities (the largest business segment is mineral resources). As for Hitachi, its status as a major Japanese manufacturer provides the ability to pass-through the impact of rising material costs to consumers. Similarly, the consumer discretionary sector consists mostly of major auto companies like Toyota and Honda which can fend off inflation through price hikes.
Meanwhile, financials – which largely comprises of banks like Mitsubishi UFJ Financial Group, Sumitomo Mitsui Financial Group – are anticipated to observe an improvement in net interest margins on the back of higher JGB yields due to policy tweaks and an eventual policy shift. Coupled with improving loan growth and greater trading activity, we believe this would translate into positive developments for the earnings of Japanese banks in the long-term.
We remain bullish on Japanese equities
Using a fair PE ratio of 18X, we project a target price of 41,300 for the Nikkei 225 Index by 2025, which translates into an upside potential of 27% as of 10 August 2023. Even with the recent developments, Japan remains as our top equity pick, with a Star Rating of 4 Stars – Very Attractive.
Figure 7: Nikkei 225 Index Price vs EPS
Table 1: Projections for the Nikkei 225 Index
|
Japan (Nikkei 225 Index) |
FY2022 |
FY2023E |
FY2024E |
FY2025E |
|
PE Ratio (X) |
19.8 |
19.3 |
16.0 |
14.2 |
|
Earnings Per Share |
1,316 |
1,684 |
2,030 |
2,292 |
|
Earnings Growth |
-24.3% |
28.0% |
20.5% |
12.9% |
|
Target Price (based on 18X fair PE ratio) |
41,300 |
|||
|
Potential Upside (%) |
27% |
|||
|
Source: iFAST Estimates, Bloomberg Finance L.P. Data as of 10 August 2023 |
||||
In summary, after decades of very low interest rates in Japan, we believe that the case for policy normalisation has strengthened as a result of higher inflation and the monetary policy divergence between the BOJ and global central banks. This is good news for the Japanese equity market, especially value stocks.
For investors seeking exposure to Japanese value stocks, we recommend the Eastspring Investments - Japan Dynamic AS SGD. We like the fund for its strong, long-term track record of outperformance against peer funds and its benchmark MSCI Japan Index.
While we recommend investors to add value exposure, its growth counterpart should not be neglected. Japanese growth stocks provide exposure to key industries such as semiconductors, electronics, robotics, and pharmaceuticals. It also provides exposure to structural trends like cashless payments and digitalisation which are at an early stage in Japan relative to the rest of the world. Thus, we believe investors can benefit from holding a blend of value and growth stocks.
Table 2: iFAST recommended products
|
Japanese Market |
Unit Trust |
ETF |
|
Value |
- |
|
|
Growth |
- |
|
|
Blended |
- |
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