Japanese sector review – what’s next for Japan and where’s the opportunity?

The Japanese economy and stock market is back on the radar of many investors. Its economic backdrop is changing as it moves out of a long-term deflationary slump, while many companies are going through a period of corporate reform.

Inflation back on track?

Japan is on a different path to some other economies when it comes to inflation and interest rates.

The main aim for the Bank of Japan (BoJ) is to boost inflation and keep it around 2%. So far this year this has broadly been achieved, partly as a weaker yen has made imports more expensive and led to higher goods prices for consumers.

Inflation rose to 2.8% in May from 2.4% in April, partly due to an increase in energy prices after energy subsidies, which were put in place after Russia’s invasion of Ukraine, ended.

Prices also rose in areas including food, housing, and transport. Higher wages paid by larger companies could help keep inflation elevated, though the hope is this will also feed through to smaller companies.

Against a backdrop of rising inflationary pressures, it’s possible the BoJ will raise interest rates in its next policy meeting in July.

Rates were last raised in March 2024, from negative rates to +0.1%, but this was the first rise since 2007.

The BoJ was quick to signal that it won’t rush any further rate rises. But with inflation on the rise, we could see another one this summer, or at the next policy meeting in October.

Another significant move by the BoJ is that it will begin to scale back its bond-buying programme. Like several major economies, the bank started buying government bonds amid the 2008 global financial crisis in an effort to stabilise bond markets and support bond yields.

Buying fewer government bonds is expected to take place over the next one to two years and could help reduce the pressure the country’s faced against a weakening yen.

While the bank will start to trim its investments, it’s unlikely to begin selling them back to the market.

Japan has high levels of debt. That means it doesn’t want to risk pushing up yields and rates too far or fast as this increases borrowing costs.

Japan has become more compelling for investors this year, as inflation and rates begin to ‘normalise’, and companies improve governance standards and place greater focus on shareholders. Domestic Japanese savers might also look to invest more in their own stock market, given that higher inflation and rates means having to make their money work harder to grow.

The Japanese stock market might look exciting now, but investors shouldn’t forget the country has faced false dawns before. As always, the trajectory is unlikely to be a straight line and no investment returns are ever guaranteed.

This article isn’t personal advice. If you're not sure if an investment is right for you, ask for financial advice. All investments and any income from them can rise and fall in value, so you could get back less than you invest.

A good year for Japanese markets

Most major global stock markets, including Japan, have performed well over the past year.

The MSCI Japan Index grew 14.18%* over the year to the end of June 2024. This is behind the 20.61% return for the broader global stock market, but it’s still an impressive return for a one-year period. As always, past performance isn’t a guide to future returns.

As the yen has continued to weaken against other currencies like the US dollar and British pound, this reduced the return for UK investors.

Over the same year, Japanese investors received a return of 26.36% from the same index. This is a reminder of the impact currency movements can have on the returns of overseas investments, both positive and negative.

Should the yen strengthen, this should boost returns for UK investors.

A weakening yen can improve the attractiveness of Japanese goods to overseas buyers, as it makes exports cheaper. This has benefited companies that export more of their goods abroad, which includes international carmakers like Toyota. It does make imports more expensive though.

Elsewhere, there’s still a big difference in the way ‘value’ and ‘growth’ companies perform.

Growth companies are expected to grow their earnings at a more predictable rate or have exciting growth potential. On the other hand, the share prices of value companies don’t typically reflect their true worth.

The value style underperformed growth for many years and experienced its worst year in recorded history during 2020 as the pandemic took hold. However, the announcement of the first COVID-19 vaccine in November 2020 acted as the catalyst for a comeback in value investing.

A push to improve the corporate governance standards of Japanese companies has also had an impact here. These changes have had a greater impact on companies with low valuations, as many were seen as having lower corporate governance standards.

Over the past year, the broader index of Japanese value companies has grown 21.62%, while growth companies have returned 6.88%.

There’s also been a difference in performance between larger companies and higher-risk small and medium-sized companies. Some larger companies that are more international in nature or offer a more diversified range of products and services have performed well. Domestically-focused small businesses haven’t fared quite so well, though have still returned 7.53%.

That said, this means some investors and fund managers believe there’s now more value and better growth potential among smaller firms.

Japan appears to be on a firmer footing, but it’s faced false dawns in the past, so there are no guarantees.

The most likely risks that could stunt market growth include a slowdown in global growth, particularly in the US (relatively stable growth in the US has kept demand up for Japanese exports).

Any significant strengthening of the yen could also take the steam out of earnings, though this could see domestic companies do relatively better.

Aside from the economics, Japanese shares currently look reasonably valued, which could bode well for long-term investors. But, as always, periods of volatility should be expected.

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 either growth or value investing.

So, when a rotation in style occurs, it can impact performance.

Over the last year, value companies have outperformed growth. 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. Past performance also isn’t a guide to the future.

Related article

Is now the time to invest in global smaller companies? – 4 fund ideas

Aidan Moyle

Investment Analyst