Insights on Corporate Governance Reform and Alpha Generation Themes in Japan's Equity Market

Our four-person panel explains Japan’s economic boom, from growing GDP to corporate sector vibrancy, and which upward trends will sustain.

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Chetan Ahya: Welcome to Thoughts on the Market. I'm Chetan Ahya, Morgan Stanley's Chief Asia Economist.

Japan is undergoing a once in a generation transformation. A country once associated with its lost decades is now seeing multi-decade highs for nominal GDP growth and equity indices.

On this special episode of the podcast, we will discuss why we are so optimistic on Japan's trajectory from here. I'm joined by our Chief Japan Economist Takeshi Yamaguchi, our Chief Asia and EM Strategist Jonathan Garner, and our Japan Equity Strategist Sho Nakazawa.

This episode was recorded last Friday, May 31st at 9 am in Hong Kong.

Jonathan Garner: And 9 am in Singapore. 

Takeshi Yamaguchi: And 10 am in Tokyo. 

Chetan Ahya: Japan's nominal GDP growth reached a 32 year high in 2023. Equity markets have reached multi decade highs, and ROE and productivity growth have been on an improving trend. Corporate sector vibrancy is returning, and animal spirits are reviving. A new, stronger equilibrium is one of robust nominal GDP growth and a sustainable moderate inflation.

This new equilibrium of stronger normal GDP growth and low real interest rates will also be supportive of Japan's capex trends. With that backdrop, let me now turn to Yamaguchi san. 

Yamaguchi-san, what makes us confident that this virtuous cycle of rising wages and prices will continue to play out?

Takeshi Yamaguchi: We think Japan's social norm of no price hike, no wage hike is changing, and a good feedback loop between wages and prices is emerging. Workers demand higher wages with higher inflation expectations and the corporate management accept their demand, as they also expect higher inflation. Japan's labor market remains structurally tight and aggregated corporate profits are now at a record high level. In addition to the pass-through from prices to wages, we are beginning to see the pass-through in the other direction from wages to prices, especially in service prices. 

The average wage hike in these spring wage negotiations was the highest in the last 33 years. So, we expect to see a gradual rise in service inflation going ahead with a rise in wages. 

Chetan Ahya: Could you elaborate a bit on the details of the capex outlook? 

Takeshi Yamaguchi: Yes. We expect Japan's private capex to exceed its previous 1991 peak this year. In the previous deflationary period, domestic nominal GDP remained in a flat range, and Japanese firms mainly invested abroad. That said, the trend of Japanese nominal GDP growth has shifted up, which will likely positively affect Japanese firms’ decision to increase domestic investment.

Also, there are various other factors supporting domestic capex, such as real interest rates remaining low, the weak yen, the government's new industrial policy supporting onshoring and semiconductor investment, and the need for digitalization and labor-saving investment on the back of structural labor shortage driven by demographic shifts.

Chetan Ahya: Thank you, Yamaguchi-san. And, you know, I can't let you go without answering this question, which is much of the focus of the markets right now. If yen depreciates to 160 again, how much upside risk to your rate path do you see?

Takeshi Yamaguchi: Our FX team expects the yen to gradually appreciate to 146 by the end of 2024, and under the assumption, we expect one hike this year in July and another one in January next year. However, if sustained yen depreciation raises domestic underlying inflation trend, we think the BOJ will respond by raising the policy rate further to 0.75 per cent in 2025.

Chetan Ahya: Thank you, Yamaguchi-san. Jonathan, let me come over to you now. You have led the debate on Japan's ROE improvement and have been bullish since 2018. How are we thinking about Japan equities from a broader Asia market allocation perspective now?

Jonathan Garner: Back in 2018, we highlighted Japan equities as what we called the most underappreciated turnaround story in global equities. And at the heart of our thesis was the idea that monetary and fiscal policy dials were now set to exit deflation, driving an improved top-down environment for corporations from an asset utilization perspective.

It's worth recalling that during the deflation era, Japan listed equities ROE averaged just 4.2 per cent for two decades, by far the lowest in global markets. That's now reached almost 10 per cent, and we're confident that by the end of next year we can be approaching 12 per cent, which would put Japan back in the middle of the pack in global equity markets.

And we think further re-rating in line with the improved ROE is likely, over the medium term.

Chetan Ahya: And how much upside do we see from here?

Jonathan Garner: Well, in terms of the target price that we published in our midyear outlook, that now stands at 3,200 for June 2025 for TOPIX. And the way that we derive that is through an earnings forecast for TOPIX, which is around 5 per cent above current consensus levels.

And in addition, a forward PE multiple assumption of 15 times, which is close to where the market is currently trading, and around about a 4 PE point discount to our target multiple for the S&P 500. So that gives us around 16 per cent upside versus current spot levels.

Chetan Ahya: Thank you, Jonathan. And you mentioned about corporate governance changes helping Japan equity markets. Sho, let me bring you in here. How will corporate governance changes drive further improvement in Japan's ROE?

Sho Nakazawa: I would say corporate governance reform, which is Tokyo Stock Exchange initiative will help fuel OE gains going forward. From the last year below 1x P/B has been a buzz word in the market, growing sense of shame and peer pressure to enhance capital efficiency for the corporate executives. And this is not just a psychological change. If we look at cumulative share buybacks amount, last fiscal year it hit a record high of ¥10 trillion, and we are seeing further record growth into this fiscal year as well.

Chetan Ahya: And what are the key alpha generation themes still to pay for within Japan equities space?

Sho Nakazawa: In terms of alpha generation, we explored three key themes within the Japanese equity landscape. So one, identifying companies with labor productivity and pricing power that can pay and absorb higher real wages; and two, finding the next cohort of corporate reform beneficiaries. Three, assessing the impact of NISA, Nippon Individual Saving Account, inflows.

I think this will drive large cap, high-liquidity value and high dividend stock. Still plenty to play for in Japan.

Chetan Ahya: Yamaguchi-san, Jonathan, Nakazawa-san, thank you all for taking the time to talk. And thanks for listening. If you enjoy the podcast, please leave us a review wherever you listen and share Thoughts on the Market with a friend or a colleague today.