The Japanese economy, after a prolonged period of stagnation, is currently experiencing a renaissance. A confluence of unique tailwinds in the current market environment suggests a supportive backdrop for future equity returns. Here, we examine reasons for this newly optimistic outlook, drawing from insights provided by Lord Abbett portfolio managers and recent market trends.
The Three Lost Decades
Japan's equity market is set to emerge from the "lost decades"—years of anemic GDP that marked a reversal of its strong and steady economic growth in the postwar years. Following twin bubbles in the equity and real estate markets in the 1980s, a subsequent crash led to banks facing challenges. At that time, the Bank of Japan decided to institute unconventional monetary policy, perceived at the time as a short-term solution, which aimed to keep short-term rates extremely low to spur business investment.
The short-term policy ran into a prolonged deflationary environment due to decreasing wages and an appreciation of the yen, along with swiftly accumulating government debt. This made it challenging for the Bank of Japan to raise rates, leading to over three decades of unconventional monetary policy.
Behind the Turnaround
But the tide appears to have turned in 2023. Several global and domestic factors have contributed to the changing dynamics in the Japanese equity market:
1. Global Inflation and Pass-Through to Prices in Japan
The world is witnessing robust global inflation for the first time in over 30 years, pushing central banks around the globe to increase rates after more than a decade of ultra-accommodative policy. In Japan, the combination of high input costs, due to increased prices of imported raw materials, and loose monetary policy, have led to a depreciating yen. This, in turn, has triggered inflation in Japan after three decades.
This is welcome news for Japan’s policymakers since it allows Japan’s economy, mired in decades of stagnant growth (upper half of of Figure 1) and deflation or disinflation[MY1] (lower half), a chance to break out by triggering private investment-led growth.
Figure 1. For Japan, the Past Few Decades Have Brought Slow Growth …
Quarterly nominal gross domestic product, seasonally adjusted, Q1 1980–Q2 2023
… and Periods of Disinflation and Deflation
Year-over-year change in consumer price index (quarterly), Q1 1980–Q2 2023
Source: Economic and Social Research Institute Japan (GDP) and Ministry of Internal Affairs and Communications (CPI). For illustrative purposes only.
2. Monetary Policy and Bank of Japan’s Stance
The Bank of Japan (BoJ), under the leadership of newly installed Governor Kazuo Ueda, is reviewing its long-standing monetary policies, referred to as Yield Curve Control (YCC). With Japan witnessing inflation for the first time in decades, the BoJ sees an opportunity to move to a path of interest-rate normalization. As a first step, the BoJ loosened its long-standing YCC policy in late July, effectively expanding its 10-year government bond yield tolerance range (i.e., the degree to which policy allows rates to move) by 50 basis points to a maximum of 1%, since the BoJ believes stable yields, along with yen weakness, will minimize the shocks due to the changes in YCC. The annual wage negotiation in Japan has also settled on moderate increases, ensuring that inflation remains in a “sweet spot” without it running rampant. With deflation ending, and assuming no near-term economic shocks, the BoJ believes that it can lead the economy from a negative, short-term interest-rate policy to a zero interest-rate policy, and finally, to a gradual return to positive short-term interest rates.
3. Corporate Behavior and Pricing Power
Due to an extended period of deflation, Japanese companies, especially ones relying on imported goods, historically maximized profits by capturing market share with lower prices and not by expanding margins, as in most other developed markets. This was largely because the Japanese consumer was averse to price hikes. However, the current trend indicates a breakthrough in this psychological barrier. The traditional Japanese business ethos of prioritizing market share over price hikes is witnessing a shift. Increasing import pressures are prompting competitors to raise prices, a crucial factor for higher profitability and increased margins.
4. Positive Earnings Momentum
The trends detailed above have, on balance, aided the profit recovery for Japanese companies. FactSet data show that 63% of the companies in the TOPIX Index reported earnings that beat analyst estimates in the second quarter, exceeding the 57% positive-surprise figure over the past four quarters. The second-quarter earnings growth rate also indicated continued progress, increasing 17.9% from a the prior-year period.
5. Stock Exchange Reform and Valuations
In January 2023, the Tokyo Stock Exchange (TSE) launched an initiative urging Japanese firms to bolster their attractiveness to investors. A pivotal aspect of this initiative mandates companies, which consistently have a trading value below their book value, to present an enhancement strategy or provide a rationale for their position. This is important as, by the end of March 2023, almost half of the 1,832 companies listed on the Prime Market–TSE's premier segment–reported a return on equity of less than 8% or a price-to-book ratio below 1.0. Such figures raise investor concerns regarding profitability, capital costs, and growth potential. Furthermore, the TSE is advocating for companies to adopt measures that amplify their long-term corporate worth, emphasizing the importance of being mindful of capital costs. Historically, certain Japanese corporate leaders have not focused on the implications of capital costs and share prices. A greater emphasis on these measures could significantly improve capital utilization and boost their market reputation. All that said, Japanese equity valuations remain low. The forward P/E ratio of the MSCI Japan Index is 14.2x, which remains below its 15-year average and represents a steep discount to the comparable U.S. benchmark, the S&P 500 Index. With half of all Japanese companies still trading on a price-to-book ratio below one, there is plenty of room for improvement with the TSE spurring a rerating of Japanese equities.
Summing Up
We believe the Japanese equity market is at an inflection point. Backed by both internal reforms and external endorsements, such as Berkshire Hathaway’s decision in June to raise its equity stakes in five Japanese trading firms, and the TSE initiatives mentioned earlier, we think the market is poised for growth. While global economic uncertainties persist, the tailwinds supporting the Japanese equity market are strong. If current trends persist, Japan has significant potential to catch up with other developed markets after a long period of underperformance. For investors, this presents a compelling opportunity to capitalize on the positive structural changes underway in Japan.
Investors can access this theme across a diversified blend of sectors and industries via three Lord Abbett vehicles: the International Opportunities Fund, the International Value Fund, and the International Equity Fund. The exposure to Japanese equities across all three of these products is at multi-year highs since we believe the Japanese turnaround has room to run for the medium and long term. Our approach to international equities employs a framework of determining sustainable competitive advantage to identify businesses capable of creating shareholder value over an economic cycle. We seek to find those quality businesses that are growing, consistently deliver high returns, and have durable cash flow.
Important Information
Lord Abbett International Opportunities Fund
A Note about Risk: The Fund invests primarily in foreign small and mid cap company stocks, which tend to be more volatile and less liquid than U.S. or large cap company stocks. Foreign securities generally pose greater risks than domestic securities, including greater price fluctuations and higher transaction costs. Foreign investments may be affected by changes in currency rates or currency controls. With respect to certain foreign countries, there is a possibility of nationalization, expropriation or confiscatory taxation, imposition of withholding or other taxes, and political or social instability that could affect investments in those countries. These risks can be greater in the case of emerging country securities. Small and mid cap companies may have more limited product lines, markets, or financial resources and typically experience a higher risk of failure than large cap companies. The Fund is subject to the risks associated with derivatives, which may be different from and greater than the risks associated with investing directly in securities and other investments. These factors can affect Fund performance.
The Fund's portfolio is actively managed and is subject to change.
Lord Abbett International Value Fund
A Note about Risk: The value of investments in equity securities will fluctuate in response to general economic conditions and to changes in the prospects of particular companies and/or sectors in the economy. The foreign securities in which the Fund primarily invests generally pose greater risks than domestic securities, including greater price fluctuations and higher transaction costs. Foreign investments also may be affected by changes in currency rates or currency controls. With respect to certain foreign countries, there is a possibility of nationalization, expropriation or confiscatory taxation, imposition of withholding or other taxes, and political or social instability that could affect investments in those countries. These risks can be greater in the case of emerging country securities. A company's dividend payments may vary over time, and there is no guarantee that a company will pay a dividend at all. The market may fail to recognize the intrinsic value of particular value or dividend-paying stocks the Fund may hold. Investments in value companies can continue to be undervalued for long periods of time and be more volatile than the stock market in general. In addition to large company stocks, the Fund may invest in mid- and small-sized stocks, which tend to be more volatile and may be less able to weather economic shifts or other adverse developments. The Fund is subject to the risks associated with derivatives, which may be different from and greater than the risks associated with investing directly in securities and other investments. These factors can affect Fund performance.
The Fund's portfolio is actively managed and is subject to change.
Lord Abbett International Equity Fund
New Fund Risk: The Fund is newly organized. There can be no assurance that the Fund will reach or maintain a sufficient asset size to effectively implement its investment strategy.
A Note about Risk: The value of investments in equity securities will fluctuate in response to general economic conditions and to changes in the prospects of particular companies and/or sectors in the economy. The foreign securities in which the Fund primarily invests generally pose greater risks than domestic securities, including greater price fluctuations and higher transaction costs. Foreign investments also may be affected by changes in currency rates or currency controls. With respect to certain foreign countries, there is a possibility of nationalization, expropriation or confiscatory taxation, imposition of withholding or other taxes, and political or social instability that could affect investments in those countries. These risks can be greater in the case of emerging country securities. Investments in either growth or value stocks may shift in and out of favor for long periods of time, depending on market and economic conditions. The Fund is subject to the risks associated with derivatives, which may be different from and greater than the risks associated with investing directly in securities and other investments. These factors can affect Fund performance.
The Fund's portfolio is actively managed and is subject to change.
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Unless otherwise noted, all discussions are based on U.S. markets and U.S. monetary and fiscal policies.
References to fund yields are for informational purposes only and are not meant to represent any specific Lord Abbett bond fund or portfolio.
Asset allocation or diversification does not guarantee a profit or protect against loss in declining markets.
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Equity Investing Risks
The value of investments in equity securities will fluctuate in response to general economic conditions and to changes in the prospects of particular companies and/or sectors in the economy. While growth stocks are subject to the daily ups and downs of the stock market, their long-term potential as well as their volatility can be substantial. Value investing involves the risk that the market may not recognize that securities are undervalued, and they may not appreciate as anticipated. Smaller companies tend to be more volatile and less liquid than larger companies. Small cap companies may also have more limited product lines, markets, or financial resources and typically experience a higher risk of failure than large cap companies.
Fixed-Income Investing Risks
The value of investments in fixed-income securities will change as interest rates fluctuate and in response to market movements. Generally, when interest rates rise, the prices of debt securities fall, and when interest rates fall, prices generally rise. High yield securities, sometimes called junk bonds, carry increased risks of price volatility, illiquidity, and the possibility of default in the timely payment of interest and principal. Bonds may also be subject to other types of risk, such as call, credit, liquidity, and general market risks. Longer-term debt securities are usually more sensitive to interest-rate changes; the longer the maturity of a security, the greater the effect a change in interest rates is likely to have on its price.
The credit quality of fixed-income securities in a portfolio is assigned by a nationally recognized statistical rating organization (NRSRO), such as Standard & Poor’s, Moody’s, or Fitch, as an indication of an issuer’s creditworthiness. Ratings range from ‘AAA’ (highest) to ‘D’ (lowest). Bonds rated ‘BBB’ or above are considered investment grade. Credit ratings ‘BB’ and below are lower-rated securities (junk bonds). High-yielding, non-investment-grade bonds (junk bonds) involve higher risks than investment-grade bonds. Adverse conditions may affect the issuer’s ability to pay interest and principal on these securities.
Glossary & Index Definitions
Price-to-Earnings (P/E) Ratio: Stock analysts calculate a price-to-earnings ratio by dividing a stock's current price by its earnings per share on a trailing 12-month basis. A forward price-to-earnings ratio is calculated by dividing a stock's current price by estimated future earnings per share.
The MSCI Japan Index is designed to measure the performance of the large and mid cap segments of the Japanese equity market.
The S&P 500® Index is widely regarded as the standard for measuring large cap U.S. stock market performance and includes a representative sample of leading companies in leading industries.
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