Does Japan’s stock market rally have legs?

0:06Pushkin. 30 years ago, the Japanese stock market collapsed. and it's always been about to come back, but never really has. But this year, this year, listeners, it came back. It's been the best performing developed market this year. It's up more than 20 % and it's attracting attention from investors all over the world, notably one Warren Buffett of Berkshire Hathaway, who traveled to Tokyo in April to invest in a couple of Japanese trading houses. So there's excitement. And today on the show, we're talking three reasons why we buy this Japan rally and maybe a couple of reasons for doubt. This is Unhedged, the new markets and finance show from the Financial Times and Pushkin.

0:45I am reporter Ethan Wu here in the New York studio, joined as ever on Tuesdays by FT Markets editor, Katie Martin. Katie, hello. Hey, Ethan, how are you going? Hey, hey, I'm pretty well. Katie, I will admit, a listener wrote in and said on our episode last Tuesday that we should call the big seven stocks of the US stock market seven up because there's seven stocks and they're going up, which I appreciated that email. But I am sick of talking about those stocks. I'm sick of NVIDIA. I want to talk Japan. How do you feel? Have you had too much fizzy pop? Is it making you feel poorly? Fizzy pop is bad for your digestion, or at least mine.

1:20Maybe I have a weak stomach. But Katie, there are three reasons that we buy this Japan rally. And they are the global context of the rally, the fact that inflation's back in Japan, and a wonkier change, but one that I think is no less important, corporate governance reform in the country. Let's start with the global context. I think this one is both the most intuitive and maybe the most important. Japan's growing a lot. It grew 2.7 % in the first quarter of this year. You just can't find economic growth rates like that anywhere in major stock markets, can you? So yeah, Japan definitely benefits from being not the US, not Europe, and not China.

2:00So it sounds kind of ridiculous, but it sort of works, So one investor I was speaking to recently was saying, look, I'm done with the US. These seven-up stocks, the kind of seven fizzy tech AI-related stocks that have been propping up the stock market this year in the US, I just don't like the look of it. It makes me a bit nervous. And in any case, valuations are really high over in the States. So where else do you look? You look at Europe and you think, I don't know, a bit of a recession potentially coming here. And also Europe has had a good year so far this year in stocks. And then you look at Asia and, you know, typically that would mean, OK, fine, let's take on some China risk.

2:38But the Chinese economic recovery from the COVID lockdowns has been really quite a severe disappointment. You look at the geopolitics and you think, I'm not keen on that either. You look at the constant risk of some sort of regulatory crackdown that comes from China, and investors are just not that into it at the moment. So they're looking elsewhere in Asia for some good opportunities, and Japan is right up there. And you can see evidence of that in what type of capital has been flowing into Japan. There's some domestic Japanese investors, but really, Katie, it's been global investors that have been powering this rally.

3:13And I talked to a portfolio manager who works on Japanese stocks recently, this guy, Nick Schmitz at Verdad. And he makes the point that you can see capital has flown where Western investors have the most easy mutual fund and ETF access to the Japanese market. They're just grabbing what's available on the shelf and buying the stocks. And I think that fits into this picture where if you're a global investor and you're looking at the options you've got, I mean, Japan looks pretty good right now, all things considered. And it's winning over some doubters. So as I'm sure you know, I do my homework, before I come and have these little chats with you, Ethan Wu.

3:49And I was just reading a note out from the BlackRock Institute. BlackRock, not a small investment house, pretty big, pretty influential. They were saying that in February, which is four months ago, they were saying we don't particularly like Japanese stocks. They went underweight, which means that you hold a smaller proportion of your portfolio in Japan than you otherwise would if you were just tracking the global benchmarks. So they just don't like it very much. Bunch of reasons for it. One of them was that they thought that monetary policy was going to tighten up. But they were saying, you know, already, they were like, already, we don't agree with ourselves.

4:25We're changing our mind, which everybody's right to do. And I like it, actually, when investment houses and banks say, we got this wrong and changed our mind. That's what they're doing. And they're saying, look, we think that there's a bunch of reasons why, actually, we think Japan can do well. So they're already sort of turning that around. So if you're starting to get the doubters to sort of switch around to your way of thinking, that's a really powerful force. Absolutely. And I think that leads us, Katie, to our second reason the Japan rally has been powering on, and that's the return of inflation.

4:53And actually, I did read that BlackRock note. This is a reason they cite. It's that inflation's back. And I think for listeners, when they think of inflation, you might think of the 4 % or 5 % that the US has. What do you guys have in the UK? Like 20%, 50 %? Easy now, 8.7%. Okay. But that's not the case in Japan. It's more like 3%, depending on what measure you look at. It's a totally manageable inflation rate. And more importantly, it interrupts what people have long decried in Japan as a deflationary psychology. And this is just the idea. If your washing machine costs$400 today and$350 tomorrow, you're going to put off that consumption until next year because it's going to be cheaper.

5:34And that just reduces spending, slows the economy, makes everyone worse off. And that turning around is a really important change. Yeah, that is exactly what Japan has been fighting against unsuccessfully for decades. And now suddenly, well, hey, it's got healthy levels of inflation. It's got wage inflation. People are seeing their pay packets grow. This is a whole different kind of setup. This is not the 11 million percent inflation that we've got in the UK that's making it difficult to afford their groceries. This is a much more healthy type of inflation that is really welcome, actually, in corporate Japan and in a lot of Japanese households.

6:07And it makes a big difference, especially when wage packages rise. So a couple of things here on the monetary policy front. BlackRock is one of the houses that's been saying when you have got inflation picking up, all of a sudden for ordinary Japanese households, keeping all of your money squirreled away in bank deposits that pay you the best part of not very much becomes less appealing. And so people look for more kind of productive places to park their cash and their savings. And a lot of that money will find its way into the stock market. And the other thing is that, so there was a change of guard at the Bank of Japan a few months ago.

6:39And everybody assumed, okay, new broom, new guy in charge of the Bank of Japan. They're going to get rid of the controls they've had on the bond market. And they're going to start tightening up monetary policy. Go Fed on the situation. and actually the still quite new governor of the Bank of Japan, Kazuo Ueda, I'm very sorry if I've pronounced his name badly, but I can't help it, I'm a Brit. He has indicated actually that he's going to be much slower to remove, you know, the policy they've had in place for a long time and indicated that actually policy is going to stay quite stock market friendly for longer than some people had assumed.

7:15And so all of a sudden you have this money that's looking for somewhere with some returns and you have this central bank that, unlike pretty much every central bank in the developed world, is opting to keep policy nice and easy. And you have actually a pretty good formula for stocks. And so that brings us to our third point. We've got the global context. We've got the fact that inflation's back. The third reason is a little wonkier, but I think it is really so important to help listeners understand why the rally is happening right now. And that's corporate governance reform. This has had maybe a decade of momentum, but it really feels like it's coming to a culmination point that companies are realizing they've got to run their house a little bit more efficiently.

7:57According to Western best practices, there's pressure from Western and Japanese activist investors who are coming in and saying, please run this more efficiently. There's pressure from the government. This is important from an investor perspective because since the bust of the late 20th century, companies have been super conservative. They've got all this cash sitting around, not doing terribly much. They've got these weird cross shareholdings where I'm your competitor and I buy you. You're my competitor, you buy me. Super weird. Yeah. And there seems to now be some momentum to kind of move the other direction.

8:29Yeah. There's a lot of momentum to push companies to think more and act more in the interest of their shareholders. So the stock BookExchange has said to companies, if your price to book ratio is less than one, which means that if the value of all of your shares in circulation are worth less than everything you own, basically, then something's got to change. You need to think about buying back some shares. You need to think about making some strategic changes. You need to think about what you can do to push your shares up. And this is guidance that's been dished out to all the companies that are listed in Japan.

9:05And look, it's just guidance. But the way that investors are thinking about it is, well, it's just guidance for now. But first of all, there's some activist investors that are backing it up. Second of all, it makes a lot of sense and companies can see this. And thirdly, what if it's the thin end of the wedge? What if it stops being just nicey-nicey guidance and starts becoming something that's a bit tougher? That's like, OK, if you don't do anything to improve this ratio, then maybe you get put on a different sort of more junior version of the exchange. Maybe you don't get looped into all the indices that means that you see a lot of passive investment flows.

9:38That sort of stuff isn't really happening now, but it's seen as a possibility. And that's one of the reasons why investors are excited. So those are the three reasons, Katie, that we're a bit optimistic for this rally. Global context, inflation, corporate governance reform. But, you know, the rally has been stalling out over the past week or two. There hasn't been a lot of fresh momentum. And I think investors are starting to talk a bit more about reasons why one might be worried. And part of that is just stocks have gone up a lot. And after a sustained period of going up, sometimes stocks tend to go down.

10:09It's a strange property. What goes up must come down? This changes everything, Ethan Wu. It does. It does. That's just a very dumb way of saying that some people think the rally's overextended, that there's been a lot of investor zeal, and there might be a reversal. And maybe the one more serious reason that the investors are a little nervous is, I mean, this has happened so many times before, Katie, hasn't it? That Western investors especially have said, oh, look, it's cheap. They're finally turning the ship around on corporate Japan. And they buy in and they end up pretty disappointed. And it's just, it's a different business climate.

10:46It's a different set of cultural and institutional factors. And I think to make it just a little more concrete, in past episodes of Western enthusiasm about the market, activist investors have come in and said, hey, you got to run this ship a little tighter. And Japanese management has said, no, F you, right? Like this is our company. You're not going to come in from the West and tell us how to run this. And I think you see some examples of that hostility toward activist investors today. I mean, there's this company, Cosmo Energy Holdings, that actually, this was a Japanese activist, but they basically told this guy Murakami to buzz off and they're using these various corporate shenanigans to dilute his ability to affect change at the company.

11:28And that's just a way of saying that management might like the way that it is. Yeah. I mean, not everyone is going to be on board with this. I think that is absolutely fair. And these things will take time and they will have knockbacks. Katie, are you excited about this rally? I feel like I am in general bullish on that. And I have been for a couple months now. Yeah. Even if we go nowhere for the rest of the year, 20 % in a year from Japan. I mean, come on. Especially in a year like this with everyone else sagging and falling behind. Yeah. All right. We're both excited. That's a pretty good place to be.

12:00We'll be back in a moment with Long Short.

12:10Welcome back. This is Long Short, that part of the show where we go long and short. One company, idea, stock, restaurant, classic piece of literature, whatever it might be, we go long and short. However, on Tuesdays so far, Katie Martin, we have neglected to include a short. Today, we are remedying that. I have a short. But Katie, do you have a long? I have a long. It's Greece. So absolutely the comeback kid of the Eurozone government bond markets. You will remember, a decade or so ago, it was an absolute bin fire. There was a massive restructuring. And it's taken a really long time for Greece to kind of get back on terms with investors.

12:50But it really has done so. And we've just had a landslide victory for the centre-right New Democracy Party in elections just the other day. And what we're seeing is two things. First of all, 10-year Greek yields are about 3.5%, which if you bear in mind that we've had a big kick higher in benchmark interest rates, that's pretty respectable. But what's really notable is that the danger gap between German and Greek bond yields, which tells you basically how much investors hate Greece has just collapsed. And so we're back down to the tightest point now since October 2021, when benchmark interest rates were much lower.

13:25And it just tells you that Greece is back and the international investors are just not worried about Greece anymore, which is an incredible turnaround. Katie, can you say the Greek Prime Minister's name? Do you want me to actually do it? Yes, I want to hear you. Okay. Kyriakos Mitsotakis. Do I win a prize for getting that name right. To be honest, I have no ability to assess whether that was right or wrong. So I'll let the Greek listeners write in and correct us. Do you know, I've done multiple podcasts in the past where I've got it wrong. So it's all right. Anyway, landslide victory. Markets are happy about it.

14:01Yes, I am sure, Katie, the liquidators of Three Arrows Capital. Listeners, this is fresh. This just came up as we were recording from Bloomberg. They have an exclusive. Just going to read the lead here. Three Arrows Capital liquidators are seeking to recover$1.3 billion from the co-founders of the failed crypto hedge fund, an amount that reflects losses the founders are accused of racking up in the months before the firm collapse. I sincerely doubt the liquidators are going to get their money. The founders, reportedly, are going on a vacation all over the world. They're going to Bali. They're chilling on the beach.

14:34They're meditating. They're zen. You know, I think those zen vibes are not really consistent with them spending enough time in liquidation court for that$1.3 billion to get forked over. I've got no information here. This is just a pure vibe. I don't believe liquidators are going to get the money back and I'm short them. Oh, ye of little faith. You know what? Sometimes these crypto tech cases take a really long time and they get their money back in the end. But OK, you can be short. I mean, listen, like I do hope to get the money back at the end of the day, but I don't know. They're not going to be very happy to hand it over.

15:04That's what I think. All right, Katie Martin, thanks for being here. We'll have you back very soon. And listeners will be back in your feed on Thursday with another episode of Unhedged. Catch you then.

15:22Unhedged is produced by Jake Harper and edited by Brian Erstad. Our executive producer is Jacob Goldstein. We had additional help from Topher Forges. Cheryl Brumley is the FT's global head of audio. Special thanks to Laura Clark, Alistair Mackey, John Schnarz, Eric Sandler, and Jess Trulia. FT Premium subscribers can get the Unhedged newsletter for free, and a 90-day free trial is available to everyone else. Just go to ft.com slash unhedged offer. I'm Ethan Wu. Thanks for listening.