Away from the Bitcoin and GameStop drama, the Japanese stock market has been quietly notching up 30-year highs. Japan has had many false dawns as a region, surging one year and drastically underperforming the next. In terms of asset allocation, it’s not well held by UK investors; while Japan’s biggest brands like Sony and Nintendo have international recognition, the market itself is not well understood outside of the country itself. What’s behind the change in fortunes for Japanese stocks and can it be sustained?

North Asia’s swift rebound from the coronavirus crisis has helped Japan’s economic prospects, with China the key to driving the region’s recovery; fund managers have noted that Asia-Pacific has started to emerge as a self-sufficient trading bloc since the crisis. Recent economic figures have inspired the stock market’s gains: while the Japanese economy contracted by 4.8 per cent in 2020, the fourth quarter growth beat expectations with a 3 per cent gain. This data helped the benchmark Nikkei breach 30,000 points for the first time since 1991. Unlike many developed markets such as the US, whose indices have hit record highs in recent years, Japan’s stock market is still off the peaks reached in the economic boom in the 1980s.

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Politics, tech and ESG

Japan has also steered away from a potential political crisis after Shinzo Abe, the country’s longest serving prime minister who pioneered many of the reforms that attracted overseas investors, resigned suddenly last summer due to ill health. Yoshihide Suga took charge in September 2020 and promised to maintain the progress of the Abe years, so investors took comfort from this seamless transition. “The pace of change in Japan may not always be to our liking, but the direction of travel is clear and will not be reversed,” says Joe Bauernfreund, manager of the AVI Japan Opportunity trust (AJOT).

Japan is also at the forefront of two popular global investment themes, tech and ESG, with a global reputation for robotics, AI, and hybrid cars. Morningstar analyst Jason Kondo says that Japan is undergoing a “leap to decarbonisation” and to that end is increasing its investment in electric vehicles. In particular, this involves investment in hydrogen fuel cells, which could replace batteries in the future as the energy source for electric cars. “Clean energy and environmental efficiency are areas where Japan has some very competitive companies that can supply solutions to the regulatory and productivity needs of customers globally,” says Nicholas Price, manager of the Fidelity Japan Trust (FJV). 

Japan may be pushing ahead in making electric vehicles, but still lags regions like Europe in terms of producing renewable electricity, says Adrian Hickey, head of Japanese equities at Pictet. But he says that Japanese companies are making great strides, albeit from a lower base, in the "S" and "G" of ESG. Despite the perception that the country's corporate culture is very male dominated, women now make up around 25 per cent of Japanese boards, he adds, and there is a greater emphasis on hiring independent directors to boards.

Active v passive

There are a range of active and passive options for investors, but they need to be aware that the most quoted index, the Nikkei 225, is weighted by share prices—so the company with the largest share price has the biggest weight in the index. The Topix index, which is weighted by the size of the company, as more representative of corporate Japan—this index has also hit 30-year highs in recent weeks. A number of index funds make it into Morningstar’s elite list of Gold-rated funds, including HSBC Japan, which has an ongoing charge of 0.07 per cent. Analyst Kenneth Lamont says that when fees are taken into account, active managers struggle to match trackers over the long term: “The yawning fee gap between this fund and that charged by the average fund in the category has proved to be a formidable hurdle for active managers.” 

Another tracker with a Morningstar Analyst Rating of Gold is iShares Japan Equity Index, which has an ongoing charge of 0.08 per cent and tracks the Topix index. Still a number of active funds are highly rated, for example JPM Japan, which has a Silver Rating and returned 38 per cent in 2020. The fund is managed by Nicholas Weindling, who also manages the JPMorgan Japanese investment trust (JFJ), whose share price has risen 64 per cent in a year. Baillie Gifford Japan (BGFD) is another closed-end option for investors that benchmarks against the Topix index, and it has a Morningstar Analyst Rating of Bronze with a one-year price return of 46 per cent.

Low growth and high profits

Why are UK investors lukewarm towards Japan and generally underweight the country? Adrian Lowcock, head of personal investing at Willis Owen, thinks volatility is part of it: the stock market does well one year, attracting interest, only to fall back the next. Companies like Sony (6758) are globally renowned, but are make less of a compelling investment story than the likes of Apple and Netflix, for example.

Japan has suffered from low growth and low inflation for years, making it seem less dynamic than other countries in the region like China and Vietnam. But the country is also an export-led nation, so is particularly sensitive to swings in global sentiment and is primed for a global recovery. Pictet's Hickey says that low domestic growth shouldn't matter to investors as long as export-led companies flourish; the current environment of economic recovery supports these cyclical companies doing well.

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See also Morningstar Guide to International Investing.