Japan sector funds review – is age of deflation over?

It was an unusual and difficult start to the year for Japan.

A powerful earthquake struck central Japan on New Year's Day, triggering tsunami warnings and leaving devastation in its wake. Just a few days later, a passenger airplane collided with a coastguard plane at an airport in Tokyo.

Events like this remind us how unpredictable life is. While Japanese investors might have had a prosperous 2023, there are often reasons why it's impossible to forecast what might be next.

Heading into 2024, we reflect on economic and stock market performance over the past year and consider what might lie ahead. As always though, the year has the potential to look very different to what we expect.

This article isn't personal advice. If you're not sure if an investment is right for you, ask for financial advice. All investments fall as well as rise in value, so you could get back less than you invest. Past performance isn't a guide to the future.

What's happening in the economy – are decades of deflation over?

After decades of deflation, inflation in Japan has been above the Bank of Japan's (BoJ) 2% target since April 2022. Inflation has been slowing in recent months, but Tokyo's core consumer price index (a measure of inflation) still rose 2.1% in December from the year before.

This is good news after years of deflation and stagnant growth. It might also encourage higher wages and consumers to buy goods and services now and not later. Because in a deflationary world, why buy something now if you could buy it cheaper later? It's a spiral Japan has been eager to get out of.

Unlike other major economies, the BoJ hasn't tightened monetary policy by raising interest rates, even with higher inflation. The central bank's governor Kazuo Ueda even announced they're in no rush to raise rates – making the BoJ the only major central bank to keep rates below zero, to try end years of deflation.

The BoJ did make one change to its policy last year though. In 2016, it set a limit on how high 10-year Japanese government bond (JGB) yields could rise. Another way it was trying to tackle stubbornly high inflation and keep borrowing costs low to boost the economy. Now, JGB yields are allowed to rise above 1%, although there's still speculation if this will make any impact.

The BoJ now wants to see more sustainable wage growth and levels of inflation before raising interest rates. The last thing it wants to do is risk pushing the country back into years of deflation and low growth.

How have stock markets reacted?

Most major global stock markets made a positive return in 2023. Japan was no exception and had a particularly strong year, growing 29.04%* in Japanese yen terms. As always, past performance isn't a guide to future returns.

Currency movements can impact performance and a weak yen against the UK's pound reduced returns for UK investors to 13.96% – though this is still an attractive annual return. It's also a reminder of the impact currency movements can have on the returns of overseas investments, both positive and negative. Should the yen get stronger, this should boost returns for UK investors.

A weaker yen also adds to higher inflation. Japan imports a lot of resources, including oil and gas, and a weak yen makes these more expensive. This has stretched domestic income and pushed inflation up.

A weakening yen can boost the attractiveness of Japanese goods to overseas buyers, as it makes exports cheaper. This could benefit companies that export more of their goods abroad.

Elsewhere, there was a big difference in the way value and growth companies performed in 2023. Growth companies are supposed to grow their earnings at a more predictable rate or have exciting growth potential, whereas the share prices of value companies don't typically reflect their true worth.

Value underperformed growth for years and experienced its worst year in recorded history during 2020 as the COVID-19 pandemic started. However, the announcement of the first vaccine in November 2020 was a catalyst for a comeback in value investing.

Last year, some of the best-performing Japanese companies were also those making strides in corporate governance improvement. Partly due to the ongoing push by the Tokyo Stock Exchange to improve the corporate governance standards of Japanese companies.

These changes had a greater impact on companies with low valuations, as many were seen to have lower corporate governance standards. This has been ongoing for several years but picked up momentum in 2023. This highlights that progress in Japan can be slow and there's more work to be done.

It's likely investors will also want a sustained improvement in inflation. Japan's wage negotiations, which tend to take place in the early part of each year, could play into this. Japanese wages haven't grown much for several years – equally, they haven't really needed to against non-existent inflation. If salaries do go above inflation, this could boost the confidence of consumers, investors and the BoJ that the era of deflation is over.

There have been false dawns before though. Economics aside, Japanese shares currently look reasonably valued to us, which could bode well for long-term investors, but as always periods of volatility should be expected and there are no guarantees.

How have Wealth Shortlist funds performed?

Japan's stock market is often style driven. This comes down to a lot of Japanese companies showing traits and characteristics that define both growth and value investing. So, when styles switch, it can impact performance.

Over the last year, value companies have outperformed growth, which has impacted the performance of Wealth Shortlist funds investing in Japan. Remember, fund managers with different strengths, styles and areas of focus will perform differently in different economic conditions.

For more details on each fund and its risks, use the links to their factsheets and key investor information below. Investing in funds isn't right for everyone. Investors should only invest if the fund's objectives are aligned with their own and they understand the specific risks of the fund before they invest.

One year is a very short timeframe. Managers with different strengths, styles and areas of focus will perform differently at different times in economic cycles.

This is why we think it's sensible for investors to invest for the long term and regularly review them to ensure they are right for you. It's also important to consider a variety of managers with different investment styles and strategies to make sure your portfolio is properly diversified.