Reasons to buy Japan and the yen after BOJ’s first hike in 17 years

• The end of negative interest rates reflects shifts in Japan’s economic landscape away from the era of the “Lost Decades”, with indications of continued improvement.

• The monetary environment remains supportive of Japanese equities. It also does not undermine the long-term investment case for Japan.

• We maintain our belief that the JPY's fortunes will reverse over time, potentially emerging as one of the top-performing major currencies by the end of this year.

• Our 2026 target price for the Nikkei 225 Index is 48,000 which represents an upside potential of 21% as of 1 April 2024. An unhedged exposure could potentially unlock greater gains.

• Over the long term, we view Japan as a very attractive investment due to its multi-year growth story.

This year has been monumental for Japan. After 17 years, the Bank of Japan (BOJ) concluded an era of negative interest rates in the March 2024 policy meeting. Simultaneously, the Japanese equity market has continued its record-setting streak. The Nikkei 225 Index reached a new all-time high of 40,888.43 on 22 March 2024, surpassing its previous peak from December 1989.

Despite these achievements, we doubt that the Japanese equity market is overextending itself. Structural factors, rather than cyclical ones, are propelling its growth. We believe this will continue to strengthen the market.

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An all-time high for Nikkei 225 is here, as we predicted. This time really is different for Japan.

Return of inflation paves way for improved growth

The end of negative interest rates reflects shifts in Japan’s economic landscape away from the era of the “Lost Decades”, with indications of continued improvement.

Core CPI which excludes volatile fresh food prices, has consistently stayed at or above the 2% target for 23 consecutive months. Furthermore, initial results from this year’s shunto wage negotiations have surpassed expectations. Rising prices and a tight labour market has prompted unions and companies to give out higher wages. This year’s talks between the largest union organisation Rengo and major companies produced pay hikes of 5.28%, marking the highest increase in 33 years (Figure 1). This is also more substantial compared to last year’s rise of 3.58%.

Figure 1: This year’s wage hikes are the highest since 1991

Such huge wage increments are expected to boost private consumption, supporting modest growth for the broader economy. In addition to enjoying heighted demand from consumers, companies should have room to raise prices in an inflationary environment, benefitting their margins and earnings. This has led the BOJ to grow increasingly confident that Japan has embarked upon a virtuous wage-price spiral capable of sustainably achieving the 2% inflation target.

Investment preferences will also start to shift. The return to sustainable inflation motivates domestic investors to seek out riskier investments, such as equities, to protect their asset values. The resurgence of the Japanese stock market after decades of disappointment offers a compelling incentive for domestic investors to start investing.

Moreover, the Japanese government has overhauled the Nippon Individual Savings Account (NISA) program this year to stimulate greater investment activity (Figure 2). It has increased the investment limit of the NISA, and scrapped the cap on tax exemptions for profits made from stock transactions.

Altogether, these factors can help to direct capital inflows into markets and support equity prices.

Figure 2: Key changes to the Nippon Individual Savings Account (NISA)

Japan will do well even with policy normalisation

In our view, the monetary environment remains supportive of Japanese equities as the BOJ has shifted from a “very accommodative” stance to one that is still “accommodative”. Despite abandoning the yield curve control (YCC) policy and discontinuing the purchase of risk assets such as equity ETFs and J-REITs, the central bank continues to engage in bond purchases. During the press conference following the termination of negative rates, BOJ Governor Ueda also tempered expectations of rapid rate hikes.

Policymakers are proceeding cautiously, mindful of the potential adverse effects of rapid increases in borrowing costs on the economy. As such, we expect the central bank to embark on policy normalisation gradually. The market has priced in rate hikes in September and December, bringing the policy rate to around 0.3%, which is still relatively low.

Borrowing costs rising at a gradual pace are unlikely to create a major burden on households and major corporations, given their strong balance sheets. Cash makes up 54% of household financial assets in Japan as at end 2023, considerably higher than its peers in the US and Europe (Figure 3). At the same time, slightly over 30% of non-financial companies in the Nikkei 225 Index maintain net cash positions, a percentage that is double that of its developed market counterparts.

Figure 3: Japanese households hold plenty of cash

Besides, we believe the normalisation of monetary policy does not undermine the long-term investment appeal of Japan.

Japanese corporations lag DM peers in capital efficiency ratios like return on equity (ROE). Corporate reforms are still underway, driven by the Tokyo Stock Exchange’s call for companies to disclose plans to improve capital efficiency. With anticipated robust future earnings from price hikes and increased consumption, companies are poised to continue the trend of share buybacks and dividend hikes, thereby benefiting investors.

Finally, Japan’s efforts to reclaim its lost status as a semiconductor powerhouse could serve to help reposition the economy towards a positive growth cycle. Its expertise in advanced manufacturing becomes a leverage as global chip companies diversify supply chains amidst US-China tensions.

For instance, Japan has announced plans to provide TSMC with up to JPY 732 billion more in subsidies to support the construction of a second chip fabrication plant that could produce chips for AI and autonomous driving (Table 1). Likewise, chip giants like Samsung and Micron plan massive investments in the country with subsidies from the Japanese government.

Table 1: Ongoing revival as a semiconductor powerhouse

Project	Subsidy	Location	Goal
Rapidus	JPY 330 billion, JPY 646 billion earmarked	Hokkaido	2 nm by 2027
TSMC’s first foundry	JPY 476 billion	Kumamoto	12 nm
TSMC’s second foundry	JPY 730 billion earmarked	Kumamoto	6 to 7 nm by 2027
Micron	JPY 240 billion	Hiroshima	Advanced DRAM
Kioxia, Western Digital	JPY 243 billion	Mie, Iwate	Advanced memory
Samsung	JPY 20 billion	Kanagawa	New chip packaging technology
Rapidus is a homegrown semiconductor manufacturer Source: Bloomberg Finance L.P., METI, iFAST Compilations Data as of 24 February 2024

(Related article: The resurgence of Japan: A new era of multi-year tailwinds with upside potential of 30% by 2025)

Yen to strengthen in time to come

A rate hike was supposed to strengthen the Japanese yen (JPY). However, the currency weakened immediately after the BOJ’s move. Then on 27 March, it slid to the weakest level in 34 years against the dollar.

Despite being the worst-performing major currency year to date, we maintain our belief that the JPY's fortunes will reverse over time, potentially emerging as one of the top-performing major currencies by the end of this year.

Concerns about the JPY's decline have prompted authorities to consider intervention. Masato Kanda, the country’s top currency official, recently emphasised that the current weaking of the yen is driven by speculation and not in line with fundamentals. Finance Minister Shunichi Suzuki echoed this sentiment, expressing urgency and readiness to take bold measures.

Fundamentally, higher rates should eventually strengthen the JPY. Ueda mentioned that the BOJ would act if upside risks to inflation increased, suggesting that the central bank remains data-dependent. We think that positive trends for wages and prices could spur inflation expectations, potentially translating to bigger price increases.

Wage developments will hold significance. In particular, small and medium-sized enterprises (SMEs) will finalise pay agreements from April to June. Should the positive momentum of wage increases extend to SMEs, the BOJ is likely to deliver more hikes this year. The central bank also has plans to eventually scale back bond purchases and allow market forces to set long-term interest rate moves.

As such, there will be more room for JGB yields to adjust upwards. With many other central banks exploring the potential for rate cuts, the policy divergence is poised to narrow the yield differential between the BOJ and foreign central banks, resulting in a gradual appreciation of the JPY (Figure 4).

Figure 4: A narrowing of yield spread should drive JPY appreciation

To be clear, we don’t anticipate mean reversion to 110 per dollar yet as yield differential between Japan and the US will remain wide. Consequently, a strengthening of the yen should still reach a comfortable level for exporters.

Meanwhile, a gradual appreciation in the JPY would continue to enhance the attractiveness of Japanese equities to foreign investors. It also helps to mitigate macro headwinds affecting corporations, such as surging import costs.

(Related article: Japanese Yen will be one of the top performing currencies in 2024)

Key investment risks

High public debt: Japan has the highest public debt load among advanced economies. Rising interest rates increases debt serving costs, potentially widening the fiscal deficit. That said, as the rise in interest rates is likely to be gradual, this may allow the government more time to adjust its budget and revenue policies accordingly.

Japan: A multi-year growth story

Our 2026 target price for the Nikkei 225 Index is 48,000 which represents an upside potential of 21% as of 1 April 2024. We suggest investors consider an unhedged exposure for potentially greater gains, given our positive outlook on the JPY.

Despite the recent rally, Japanese stocks still tend to have low valuations. More than 30% of companies in the Nikkei 225 still trading below book values, in contrast to the S&P 500’s 3%.

Given the BOJ’s careful policy normalisation, Japan remains as one of our top equity picks. Its growth narrative is driven by structural factors rather than cyclical ones, presenting an attractive long-term investment opportunity. For those who missed the initial rally, now presents a second chance to capitalise on what could be a multi-year uptrend.

Our recommended products are the Eastspring Investments - Japan Dynamic AS SGD and the iShares MSCI Japan ETF (NYSE:EWJ). For investors who prefer to receive distributions, they may consider the Nikko AM Japan Dividend Equity JPY or Nikko AM Japan Dividend Equity SGD.

Lastly, investors seeking small-cap exposure can look towards the BNY Mellon Japan Small Cap Equity Focus H Acc SGD-H (note that only hedged share classes are available for this fund).

In terms of single stock picks, we like the Japanese mega banks – Mitsubishi UFJ Financial Group (NYSE:MUFG), Sumitomo Mitsui Financial Group (NYSE:SMFG), and Mizuho Financial Group (NYSE:MFG). These banks are poised to benefit from improvements in net interest margins with higher rates, alongside increased investment activity which supports their non-interest income.

(Related article: Japanese equities are entering a new era. Here are some stock ideas you can bank on.)

Figure 5: Share prices are driven by earnings

Table 2: Projections for the Nikkei 225 Index

Nikkei 225 Index	2023	2024	2025	2026
PE Ratio (X)	27.3	21.9	18.6	16.6
EPS	1226	1814	2135	2400
Earnings Growth	-14.4%	48.0%	17.7%	12.4%
Target Price (based on 20X fair PE ratio)				48,000
Potential Upside				21%
Source: Bloomberg Finance L.P., iFAST Estimates Data as of 1 April 2024

Declaration:

For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) and the analyst who produced this report hold a NIL position in the abovementioned securities.