Following a transformative year for Japanese equities, what lies ahead for 2025?
It was a pivotal year for the Japanese economy and its stock markets. Head of Japanese Equities Junichi Inoue discusses the implications and key risk for investors in 2025.
5 minute read
Key takeaways:
- In 2024, Japan experienced a significant shift in its economy with the Nikkei 225 reaching its highest level since 1989, and the end of a long-standing zero interest rate policy.
- This is leading to positive implications for both businesses and consumers. Capital spending is rising, while consumers are accepting price hikes that enable companies to increase profit margins.
- A focus on quality and idiosyncratic risk in stock selection to capitalise on structural changes and corporate governance improvements, while remaining vigilant of risks to Japan’s moderate economic recovery will be key in 2025.
2024 was the year when investors recognised a regime change in the Japanese economy, reflected in the Nikkei 225 Average Index registering its highest level in March after its last peak some 35 years ago. Contrary to initial market consensus, mild inflation continued where Consumer Price Inflation (CPI) remained above the Bank of Japan’s inflation target of 2%, leading to the decision to end an eight-year-long zero interest rate policy in March. This was followed by a rate hike in July, with further hikes expected ahead. Japan’s structural issue of labour shortages suggest that wage increases and mild inflation can continue.
Gamechanger: rate hikes and corporate governance improvements
The revival of “a world with positive interest rates” for Japan after an absence of almost two decades has firstly, changed corporate investment behaviour. Delaying investment decisions had become a risk. Now, despite record capital expenditure, this continues to rise led by investments to improve productivity. Secondly, we think in 2025, it could also lead to meaningful changes in consumer behaviour, as price hikes are now becoming more acceptable to consumers and recognised as a norm.
Corporate governance reform has been a long-standing focus. In 2023, improvements driven by Tokyo Stock Exchange initiatives positively impacted the broader market. In 2024, we saw a more proactive stance from leading companies. For example, the property & casualty insurance (P&C) sector announced that all cross-held shares (holdings in other stocks) would be unwound within five years. The proceeds are to be allocated to fund share buybacks and mergers and acquisitions, which will support sustainable growth in earnings and dividends per share (EPS and DPS). Previously, insurance premiums were not priced properly. With the unwinding of cross-holdings, premiums will be higher but able to more sufficiently cover risks.
Such initiatives are particularly evident in regulated sectors, such as financials, but the pursuit of an optimal capital structure has also become common in other industries. This is noteworthy because as Japan’s relationship-based economy through affiliations and cross-holdings is ending, it transforms the economy into one that pursues profit maximisation.
The Japanese stock market crash in August this year was a noteworthy event. The market’s risk appetite has not fully recovered from the aftermath, leaving opportunities for stock picking. Several factors contributed, but the excessive trades shorting China-related stocks while going long on Japan played a major part. The year-to-date (YTD) return up to the peak just before the crash was c.18%, significantly exceeding the year’s EPS forecast growth of about 8%, and the TOPIX compound annual growth rate (CAGR) of circa 14% since 2012 (the start of Abenomics). The market weakness can also be understood as an adjustment of excess trades, in hindsight.1 The YTD return until mid-December (15 December 2024) after overcoming the crash was 16% despite the high volatility and the drop in August.2 2024 therefore looks to have been a reasonably good year overall for Japanese equities.
A focus on quality and idiosyncratic opportunities is key
We believe the biggest risk for Japan in 2025 is that following decades-long stagnation, its moderate economic recovery could face a slowdown, denting business and investor sentiment. The Japanese market’s earnings growth rate for 2025 is expected to be in the high-single digits, which looks to be achievable. However, while the market expects the financial sector to lead this growth, a slowdown in the manufacturing sector could be pronounced. The latter could have some impact on profits if the top line slows down, as costs cannot be reduced quickly.
Unlike previous cycles where we have not normally seen rate cuts when the economy is strong, interest rate cuts have already begun, with the effects of this expected to emerge from mid- 2025. Additionally, compared to the past few years, the risk of recession is considered to be increasing. This means for active investors, stock selection will focus more on quality and idiosyncratic opportunities rather than be market-driven.
The Japanese economy is no longer the export-dependent model it once was, as many companies have localised their businesses, reducing the impact of currency exchange on profits. But Tokyo Stock Exchange-listed companies still rely on around nearly half of their sales from abroad, hence they remain tied to the fortunes of the global economy.
Japanese equities can offer some resilience
However, due to Japanese stocks’ comparatively low valuations versus global equities, and ongoing governance reforms contributing to return-on-equity improvements, we expect the market to demonstrate a certain level of resilience. For these reasons, we believe Japanese equities can be considered an attractive risk-reward asset class, deserving of an allocation in a diversified portfolio, particularly those companies that are exposed to global markets and global growth.
1 Source: Bloomberg, TOPIX price returns in JPY year-to-date to 31 July 2024; TOPIX CAGR price returns in JPY since the start of Abenomics in 2012, 14 November 2012 to 29 November 2024; Citi forecast EPS growth for financial year end 31 March 2025. Past performance does not predict future returns. There is no guarantee that past trends will continue, or forecasts will be realised.
2 Source: Bloomberg, TOPIX price returns in JPY, 29 December 2023 to 13 December 2024.
Abenomics: a set of economic policies championed by Japanese prime minister, Shinzo Abe, using a three-arrow approach of increasing money supply, increasing government spending to stimulate the economy, and undertaking economic and regulatory reforms to make Japan more competitive in the global market.
CAGR: measures an investment’s annual growth rate over time, including the effect of compounding (where any income is reinvested to generate additional returns). CAGR is typically used to measure and compare the past performance of investments or to project their expected future returns.
Corporate governance: a set of rules, practices, and processes used to run and control a company. This includes key areas such as environmental awareness, ethical behaviour, corporate strategy, compensation, and risk management.
CPI: Consumer Price Index is a measure that examines the price change of a basket of consumer goods and services over time. It is used to estimate inflation. ‘Headline’ CPI inflation is a calculation of total inflation in an economy, and includes items such as food and energy, where prices tend to be more volatile. ‘Core’ CPI inflation is a measure of inflation that excludes transitory/volatile items such as food and energy.
Cross-holdings: occurs when a publicly-traded company holds a significant number of shares of another publicly-traded company to reinforce business relationships.
DPS: Dividends Per Share is the total dividend a company pays out over a 12-month period, divided by the total number of outstanding shares
EPS: Earnings Per Share is the bottom-line measure of a company’s profitability, defined as net income (profit after tax) divided by the number of outstanding shares.
Idiosyncratic factors: specific to a particular company and have little or no correlation with market risk.
Nikkei 225: also known as Nikkei Stock Average, it is a price-weighted equity index consisting of 225 stocks in the Prime Market (companies that centre their business on constructive dialogue with global investors) of the Tokyo Stock Exchange.
ROE: a company’s net income (income minus expenses and taxes) over a specified period, divided by the amount of money its shareholders have invested. It is used as a measurement of a company’s profitability, compared to its peers. A higher ROE generally indicates that a management team is more efficient at generating a return from investment.
Share buybacks: a company buying back its own shares from the market, thereby reducing the number of shares in circulation, with a consequent increase in the value of each remaining share. It increases the stake that existing shareholders have in the company, including the amount due from any future dividend payments. Buybacks typically signal the company’s optimism about the future and a possible undervaluation of the company’s equity.
Short position: shorting is used with the intention of making a profit or to offset a financial risk. In currency trading, a long position is taken on one currency and a short position on another. Currencies are traded in pairs with their value in relation to each other determining if a trader makes a profit. A trader may also short a currency solely to profit from a fall in the value of the currency.
Top line: a company’s revenues or gross sales.
TOPIX: also known as the Tokyo Stock Price Index, is a capitalisation-weighted index of all the companies listed on the First Section of the Tokyo Stock Exchange and is widely regarded as a broad benchmark for Japanese stock prices.
Volatility: the rate and extent at which the price of a portfolio, security or index, moves up and down. If the price swings up and down with large movements, it has high volatility. If the price moves more slowly and to a lesser extent, it has lower volatility. The higher the volatility the higher the risk of the investment.
Zero-rate policy: when a central bank sets short-term interest rates at or close to 0% to stimulate economic activity by encouraging low-cost borrowing and access to cheap credit.
5 minute read
Key takeaways:
- In 2024, Japan experienced a significant shift in its economy with the Nikkei 225 reaching its highest level since 1989, and the end of a long-standing zero interest rate policy.
- This is leading to positive implications for both businesses and consumers. Capital spending is rising, while consumers are accepting price hikes that enable companies to increase profit margins.
- A focus on quality and idiosyncratic risk in stock selection to capitalise on structural changes and corporate governance improvements, while remaining vigilant of risks to Japan’s moderate economic recovery will be key in 2025.
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