Japan’s economy is undergoing a significant transformation with the end of deflation, the return of steady growth and a renewed corporate dynamism, which could set up a compelling opportunity for global investors.
“Moderate inflation and the best period of nominal economic growth since the collapse of its asset bubble in the early 1990s are helping usher in a generational shift in Japan’s economy and markets,” says Morgan Stanley’s Chief Japan Economist, Takeshi Yamaguchi. “Large employers have cast aside what used to be a well-established practice of no wage hikes and no price increases, beginning a positive cycle of increases in both.”
The change in Japan’s economy is remarkable after three decades of stagnation. Nominal GDP growth averaged 3.5% in 2022 and 2023, more than double the growth rate from 2013 to 2019. Japan essentially didn’t grow from 1993 to 2012—when nominal annual growth was negative 0.03%. On the inflation front, Japan’s headline consumer price index has risen by 2% or more for 24 straight months, through March of this year. By contrast, in the preceding 30 years, headline inflation was at or above 2% for just 27 months total.
Behind the positive economic headlines are a number of supportive trends: Wage growth has reached a 30-year high, while corporate governance reforms have helped to improve return on equity, which gauges a company’s profitability. Additionally, policymakers are combining monetary, fiscal, trade and industrial policy to lift economic productivity and enhance sustainability.
This Time Is Different
To be sure, several previous periods of optimism about a Japan turnaround have ended in disappointment. Some skeptics continue to suggest that high debt and weak demographics will bring back low inflation or deflation. According to this argument, global inflationary pressures in the past several years drove Japan’s reflation, and once global inflation eases, Japan will see its chronic “lowflation” return.
However, Morgan Stanley Research believes the right domestic policy choices have created the current positive economic turn. For instance, while global inflation helped boost Japan’s reflation initially, the Bank of Japan kept its monetary policy accommodative even as other developed market central banks tightened dramatically. Japan’s nominal GDP growth is likely to be strong this year, at 3.1%, which would put it on track for the strongest two-year period of growth since 1991.
Japan Tops Stock Picks in Asia
Against this backdrop, Japanese stocks are likely to benefit from a virtuous cycle of rising return on equity, strong growth in earnings and higher valuations relative to those earnings.
Morgan Stanley took the view that Japanese equities were an underappreciated turnaround story in 2018 on the idea that monetary and fiscal policy dials were set to exit deflation, driving an improved top-down environment for corporations from an asset utilization perspective. Now the case has only grown stronger.
“Morgan Stanley’s longstanding positive outlook on Japan is now more widely accepted by investors,” says Jonathan Garner, Morgan Stanley Asia Equity Analyst. “But the economic and structural policy reform agenda means improving returns on Japanese equities still have room to play out.”
Japanese equities remain Morgan Stanley’s top pick across Asian markets, and they are preferred versus emerging markets overall. Analysts predict further gains and have raised their forecast for the TOPIX index to 3,200 by mid-2025 from 2,800 previously.
They forecast return on equity for Japanese stocks to reach 12% by the end of 2025 versus 10% currently, helped by further margin improvement in the majority of industries and strong top line revenue growth driven by domestic GDP growth as well as Japanese firms’ success in overseas markets.
Governance and Other Positives
While investors have long been skeptical of Japanese equities due to inefficient corporate governance, recent improvements may be removing the stigma. Regulatory changes, led by the Tokyo Stock Exchange, aim to improve capital efficiency, shareholder value and management accountability. Companies that make governance changes such as improving board independence may see subsequent improvement in their stock price.
In addition to the recent shift in corporate mindset, new policy developments may help Japanese firms, including a law that encourages domestic production of certain sensitive technology, as well as indications of increased defense spending. And Japan appears to be benefiting from the desire of countries, including the U.S., to diversify manufacturing of key technology products. Japan’s foreign direct investment has been rising, bucking the trend in other developed economies.
Banking, which is an important component of Japan’s equity markets, also may be poised for gains. Banks’ return on equity may improve as much as a couple of percentage points from roughly 7% at present and could reach near double digits over the medium term, helped by higher interest rates, overseas growth strategies and better cost management. Wealth and asset management may prove to be an attractive area for growth as the saving and investment habits of Japanese households shift, following changes to the national savings scheme that allow for permanent tax exemptions and higher annual investment limits.
“Financial markets are entering a new era in Japan,” says Magdalena Stoklosa, Morgan Stanley’s Director of Asia Research. “As inflation rises, the need for higher returns is self-evident. This is likely to continue strengthening the equity market.”
For deeper insights and analysis, ask your Morgan Stanley Representative or Financial Advisor for the full report, “A Revitalized Japan,” (May 19, 2024).
