Why some investors are turning to Japan
Morgan Stanley Research09/20/23
Summary: A rise in Japan’s nominal GDP after a long period of flatlining could create opportunities.
Asia is emerging as a destination for investors seeking opportunity amid a slowing global economy–and Japan, in particular, may be a regional standout.
The world’s third-largest economy has managed to emerge from deflation without runaway inflation, and capital expenditure from the private sector is rising. But perhaps most significantly, Japan’s nominal gross domestic product (GDP), which measures output at current prices, is rebounding.
“This marks a momentous change for Japan after economic growth has languished in negligible or negative ranges for years,” says Morgan Stanley’s Chief Japan Economist Takeshi Yamaguchi.
Meanwhile, the government and businesses are working together to secure political autonomy, supply-chain security, and economic prosperity through faster technology adoption; a more flexible, mobile, and skill-based labor market; better governance; and fiscal sustainability.
Japan's shift to solid nominal growth is important for equity market returns, and the Tokyo Stock Price Index (TOPIX) could increase by 7% from today's levels. Here’s some information that investors need to know.
Japan's shift to solid nominal growth is important for equity market returns, and the Tokyo Stock Price Index (TOPIX) index could increase by 7% from today's levels.
Japan’s growth outlook
Nominal GDP growth, which covers price changes for the entire economy and is the sum of real GDP growth, is forecast to reach 1.1% for 2023 and 2024.
This real growth may be accompanied by moderate domestic inflation and an improvement in the difference between export prices and import prices. Consequently, Morgan Stanley Research stated that Japan's nominal GDP growth may approach 5% in 2023, its highest since 1991. The nominal growth trend could then shift up above 2% over the medium term after this temporary surge.
This higher growth trend in Japan also implies growth for employee compensation and corporate earnings, a large increase in tax revenue, and potentially positive effects on asset prices, says Yamaguchi.
What Japan’s growth could mean for stocks
“In the era of higher nominal GDP we expect Japanese stocks to outperform, driven by five factors,” says Asia and Emerging Market Equity Strategist Daniel Blake.
- Faster revenue growth: Sales for companies focused on the domestic market should see some acceleration alongside nominal GDP as they increase prices and/or sales volume.
- Improved profit margins: Operating profit margins should benefit as companies can adjust their product mix more easily and pass through increases in input costs to final prices. Increased sales should offset companies’ fixed costs, even for those sectors with limited pricing power, such as department stores and food and beverage.
- Central bank normalization: Despite the return to inflation, the Bank of Japan is unlikely to start raising interest rates soon, and some economists expect the central bank to have loosened its anti-deflation measures by the second half of 2024 and that these moves could be neutral or even potentially positive for stocks.
- Investor shift to equities: Japan's households are generally conservative in their investment portfolios, partly as a result of the longstanding lack of inflation. Some economists expect that the combination of a new inflation tax and higher nominal returns on equities, alongside planned capital market overhauls, could lift domestic ownership of Japanese equities.
- Higher valuations: A comparison of Asian and emerging equity markets based on price-to-book ratio and return on equity found that the MSCI Japan index, which measures the performance of large and mid-cap segments, would be trading around 25% above current valuations, driven in part by higher nominal growth expectations.
The grand strategy in focus
Japan’s era of nominal growth coincides with a national “grand strategy,” which Prime Minister Fumio Kishida has called a “new form of capitalism.” The aspirations are national security and economic prosperity, despite adverse demographics trends at home and geopolitics abroad.
“This is expected to bring big changes, especially to sectors such as energy, agriculture, health care, artificial intelligence, technology and education,” says Robert Alan Feldman, Senior Advisor at Morgan Stanley MUFG Securities. “And raise income for both capital and labor.”
To achieve its aspirations, Japan must move quickly and decisively in four areas.
- Faster technology diffusion: Economic transformation depends on the rapid diffusion of technology. The Japanese government and companies have excelled at developing technological solutions yet need to gain ground on decision-making and action.
- Greater labor market liquidity: New technology cannot spread without a workforce that is able to adapt. Companies will need to invest in reskilling the labor force.
- Better public and private governance: The private sector has made great progress in corporate governance, but still needs more attention to financial efficiency. The public sector needs better internal information sharing and faster decision procedures.
- Fiscal rebalancing: The government could reduce costs by using technology in traditional spending areas like medical, pensions, and welfare while changing rules in others, such as raising the age at which workers can receive pensions. Technology-based cost reductions would reduce the need for tax hikes.
Japan has already made some headway on several key elements in the grand strategy, such as corporate governance and technology diffusion. However, labor markets, national governance, and fiscal reform have been slower to advance.
"Room for improvement is quite substantial and suggests that investor attention to the progress of Japan's emerging grand strategy is warranted," says Feldman.
The source of this article, Japan Hits a New Era of Growth, was originally published on July 17, 2023.