Japan’s GDP and the Nikkei’s Milestone: Don’t Call It a Comeback

Editors’ Note: MarketMinder doesn’t make individual securities recommendations. The below simply represents a broader theme we wish to highlight.

Japan got a double dose of good news on Monday. First came Q4 2020 GDP, which grew the fastest among developed-world nations reporting thus far—but not enough to recoup all of the earlier decline. Then the Nikkei 225 index hit 30,000 for the first time since its bubble imploded in 1990—a nice milestone, yet also not quite enough to recoup all of the earlier decline. We wouldn’t read much into either development, although we do think there are a few interesting nuggets for investors.

Take GDP. Q4 growth did indeed hit 12.5% annualized, beating the US, UK and all eurozone nations reporting thus far.^[i] As much of the coverage has noted, Japan’s COVID experience deserves some of the credit here. The second wave didn’t hit Japan as hard as it did America and Europe, helping the country avoid a second round of lockdowns last year. While westerners stayed hunkered down, Japanese folks were largely able to travel and enjoy some winter revelry.

But any economic boost from this seems unlikely to last, as the government took a lot of flak from voters for its more lax approach. With his approval rating down (and elections looming later this year), Prime Minister Yoshihide Suga returned the country to a state of emergency in January, resuming some of the closures last year. In short, consider this another reminder that GDP looks backward and doesn’t show what comes next—which is what markets are more concerned with.

More interesting to us is the breakdown of GDP’s categories, which we think is a microcosm of how investors should approach Japan right now. Total quarterly output is only -2.9% below its peak in Q3 2019, when a sales tax hike scheduled for that October pulled demand forward.^[ii] So Q4’s output being that close to a peak that was somewhat artificially inflated is no small feat.

But GDP got a hefty assist from government spending, which hit an all-time high in Q4 2020. Private demand isn’t faring as well. Consumer spending is still down -5.3% from its high, and it is at levels last seen way back in 2011.^[iii] Gross private domestic demand, which measures exactly what its name implies, is down -6.3% from its peak and at 2012 levels.^[iv] US consumer spending, meanwhile, is down just -2.6% from its peak and is at late-2018 levels.^[v] In our view, that shows just how much Japanese domestic demand has struggled over the past decade. For all the chatter about a boom under prior Prime Minister Shinzo Abe, the past decade was really a tug of war between massive stimulus attempts and two sales tax hikes. That posed stiff headwinds against Japanese companies that relied on domestic demand—headwinds that persist even now, in our view.

You can see this another way in some of the trivia surrounding the Nikkei’s journey back to 30,000. For instance, as Reuters observed Monday: “None of the Japanese banks that topped the list of companies with biggest market capitalization in 1990 exist now, as they subsequently suffered massive loan losses and repeated mergers to survive. Tokyo Electric Power Co, the biggest firm outside banks back then, became irrelevant for investment in 2011 after the Fukushima nuclear plant disaster. Today, the market is led by Toyota Motor, one of the country’s last bastion of exporters, followed by Masayoshi Son’s SoftBank Group, which was not listed three decades ago, and tech companies.”^[vi] Even in their consolidated, now-huge form, banks have been battered by negative rates and quantitative easing, which flattened the yield curve. Policymakers advertised these tools as stimulus, but in practice they made it difficult for banks to lend and support domestic demand. Tech and the big automakers, most exposed to international demand, were more immune to those obstacles and able to thrive.

With all that said, we don’t think this milestone is quite as significant as most coverage suggests, as the Nikkei is a more diversified version of the Dow Jones Industrial Average—a price-weighted index, which doesn’t include dividends and gets skewed by share prices. A properly constructed index like the S&P 500 and MSCI World weights companies by their market capitalization, with the biggest companies having the most influence—much more logical than a tiny company with few shares and a high per-share price skewing the index. When you include dividends and measure it in yen for consistency with the Nikkei, the MSCI Japan has already passed its 1990 high. Its relatively large weighting in Tech and huge exporters is no small reason why.

Looking ahead, we don’t see Japanese market drivers changing all that much. Absent deep structural reform, domestic demand probably remains lackluster. With an unpopular government focused most on the pandemic, reform in the near future seems unlikely. That means multinationals and especially growth-oriented and Tech-like Japanese companies probably remain the most optimal selection for global investors positioning within Japan.