Japan: the land of the rising interest rates

Please note: All data referenced in this article are sourced from Bloomberg unless otherwise stated, and is accurate at the time of publishing.

Key Points

• What a 12 months for Japan. Local equity markets have hit a fresh peak for the first time since 1989, inflation is at last on track to climb to its 2% target for the first time in decades and business sentiment is rising
• After a prolonged period of deflation, interest rates are at last beginning to normalise – the Bank of Japan is expected to raise rates twice over the coming twelve months, reaching a terminal rate of 0.5%
• Investors also seem to be listening to the new drum beat. Japanese equities are up by 41% in local currency and by 33% in US dollar terms since October 2022 (in line with global equities)
• On a longer-term outlook, the picture also is encouraging. Cyclically-adjusted price-to-earnings ratios suggest average annual returns of 9.2% in the next ten years, against 7.1% for their global peers

Japan emerged from the ruins of the second World War as an economic powerhouse in subsequent decades. An impressive mix of innovation, market-leading manufacturing processes and strong export growth helped to propel it into the world’s second largest economy (until usurped by China in 2010¹).   

However, Japan’s boom crashed to a dramatic halt in the early 1990s, as the economy was rocked by the bursting of the asset bubble, the impact of a rapidly ageing population and poorer productivity growth. Its economic prowess was further dented by increased competition from elsewhere, a prolonged period of deflation and dire levels of domestic consumption.  

The lost decades 

The authorities tried to turn around the country’s fortunes through massive government stimulus programmes, expansive monetary policies and much restructuring. These aggressive measures, however, had minimal impact; hence why this period is widely known as the ‘lost decades’.    

As a result of its stagnating economic performance, Japan tumbled down the global gross domestic product (GDP) league table. Indeed, the country was demoted to fourth place in February when measured by US dollars, this time being overtaken by Germany², even if some of this turn of events can be attributed to a much weaker yen.  

There is little doubt the country’s global influence has declined over the past 30 years. According to data produced by Japan’s Cabinet Office, its share of the world’s nominal GDP plunged to just 4.2% in 2022 from a peak of 17.8% in 1995.  

Demographic decline  

Structurally, Japan struggles with its aging population and outdated working practices. The country is regularly ranked as having the world’s oldest people. More than one in ten of the population are now aged 80 or older, and nearly a third are over 65.  

The combination of an older population, low birthrate and lacklustre levels of immigration has created a huge financial burden for the state. It has resulted in a reduced labour supply for companies that are desperate to find workers.  

On a more positive note, the percentage of women participating in the workforce has risen substantially over the past decade, rising from 47.6% in 2014 to 53.6% in 2023.  

An economy on the mend? 

Despite its significant structural issues, the outlook for the Japanese economy has been slowly improving. Industrial production and exports have been relatively resilient and should continue to benefit from the recent stabilising of international demand.  

The latest Tankan survey showed that domestic business sentiment has improved and the largest service-sector companies are at their most bullish on prospects in three decades³. Inflation expectations have also been rising.  

Private consumption growth has been positive and should be supported by pent-up demand, rising wages and supportive fiscal measures. Technological advancement is helping to tackle the shortage of labour and digitalisation should help with its productivity issues.  

Inflation on the up 

After a prolonged period of deflation, price rises are starting to materialise. In March, the Bank of Japan’s (BoJ) core consumer price index (CPI) rose to an annual rate of 2.9%. The key driver of inflation was rising labour cost, as higher wages were passed through to prices.  

At the Spring negotiation round, Japanese trade union workers were granted the largest wage increase in three decades, equating to a 4% rise in pay. Inflation is also anticipated to get a boost from the easing of energy subsidies, higher oil prices and weaker Japanese currency. We expect core CPI to average 2.8% this year, and 2.2% in 2025.  

The BoJ took some early steps towards policy normalisation in March. The central bank exited its negative interest policy, abandoned yield curve control and terminated its asset-purchasing programme.  

Given the presumption that inflation is at last on a path towards the 2% target level by the summer, the BoJ is likely to hike rates by 0.25% in July, followed by a further quarter-point increase by April next year, making the terminal rate for this cycle 0.5%.  

Japanese equities turn back time  

After a prolonged period of underperformance, the benchmark Nikkei 225 index recently broke through the 40,000 mark for the first time, setting its first new high since all the way back in 1989.   

The recent outperformance of Japanese equities against many other markets in local currency terms has been driven by improved earnings and superior price-to-earnings (P/E) valuations. Domestic equities have risen by 41% in local currency terms since the lows of October 2022 and by 33% in US dollar terms, in line with global equities.

However, on a one-year view, Japanese equity valuations don’t seem to compensate for all the economic uncertainty and currency risk. Local shares are very sensitive to FX moves. A potential strengthening of the yen represents another source of risk as policy normalisation takes hold.  

Based on forward 12-month price-to-earnings ratios (PEs), Japanese equities are trading at a 7% premium to their 10-year average. Their forward dividend yield of 2.3% is broadly in line with global equities.

On the positive side, earnings momentum has been extremely positive, benefiting from the weaker Japanese currency. The growth policy trade-off remains favourable, with a relatively accommodative BoJ policy and resilient growth. In addition, domestic stocks have re-rated on anticipated improvements in corporate governance.  

The long-term outlook for Japanese equities is more attractive than it has been for many years. Cyclically-adjusted P/E ratios are consistent with total annualised returns of 9.2% over the next decade, versus 7.1% for global equities. While this is the best expected return among other top-four economies, the upside potential in the near term, in local currency, looks more limited.