Nikkei Surpassed the 1989 Record, But Comparisons Offer Reasons for Concern

Nikkei Surge & Reasons for Concern

The Japanese stock market had a blockbuster 2023, with JPN225 gaining nearly 30%. The rally carried on to the new year and culminated to February's record high, surpassing the one set in the distant 1989. There are many factors attributing to the attractiveness of Japanese equities, from high earnings, to structural reforms and favorable monetary policy.

A market-friendly Prime Minister who tries to direct savings into investments, is among those. Enhancing the Nippon Individual Savings Account (NISA) initiative is a key pillar of PM Kishida's strategy, a program that exempts eligible individuals from taxes on capital gains and dividends ^[1]. According to a recent speech by the PM, Japan has "more than 2,100 trillion yen, or $14 trillion, in household financial assets, most of which are owned as savings". ^[2]

Authorities have been making structural efforts to improve corporate governance of listed companies and boost valuations. In the latest such endeavor, the Tokyo Stock Exchange started publishing a list of companies that have disclosed plans to increase their capital efficiency. The first report showed that 40% of the Prime companies (660) have disclosed information regarding the "Action to Implement Management that is Conscious of Cost of Capital and Stock Price". ^[3]

The government is also looking to attract inflows from abroad with their initiatives and these appear to be working. Data form the Tokyo Stock Exchange (TSE) show foreign investments of around ¥3.5 trillion in the Prime offering (the largest companies) in 2023, in stat contrast with the outflows of the prior year. ^[4]

The influx of capital from abroad is partly a result of the weak Yen, which makes domestic stocks cheaper for foreign investors. The Japanese currency lost around 7% against the US Dollar in 2023 and stays under pressure this year, close to three-decade lows. The main reason for the Yen's demise is the ultra-loose policy setting from the Bank of Japan, at a period when its major counterparts have tightened aggressively.

In order to combat decades of deflation and spur growth, the BoJ has kept in place the negative rates regime, the yield curve control (YCC) policy and the quantitative and qualitative easing (QQE) program, which were initiated in 2016. Although it has been reluctant to change stance, policymakers have already taken steps towards normalization and have hinted at the eventual exit from the unconventional dovish setting, as core inflation has stayed above the 2% target for almost two years.

A less accommodative stance and a rise in rates could strengthen the Yen and rattle equity markets, especially as its major peers like the Fed are about to move in the opposite direction and start lowering them.

After its record high in December 1989 when the Yen was again weak, JPN225 entered a protracted slump and the comparisons with the current period act as cautionary tale. After having kept interest rates low for a couple of years, the Bank of Japan embarked on tightening cycle in May of 1989, to preempt an increase in price pressures, amidst elevated real estate and stock prices. This round ended with 350 basis point of hikes, taking rates from 2.5% to 6% in August 1990. By that time, Nikkei had erased more than 30% from its record peak and continued to slump after that.

If history is any guide, there is reason for concern around the viability of the JPN225 rally. After the 1989 peak the index went into a freefall as the central bank shifted to restrictive stance, the asset bubble burst and Japan entered into its "Lost Decades". However, the similarities have limitations.

The Bank of Japan is reluctant to start raising rates and it seems unlikely to tighten as aggressively as in 1989-1990. Even then, the Nikkei continued to rise after the restrictive cycle had begun, before eventually reversing. Furthermore, back then there were heightened fears of a bubble, which seem to lack this time around. As described above, the Nikkei's latest surge is partly attributed to structural reforms that create optimism for a more sustainable strength.