Yet another Japan stock rally fizzles out as economic reforms disappoint

Japan has squandered its chances to properly raise interest rates, abandon the weak yen policy and put strong reforms in place

William Pesek

Published: 4:30pm, 3 Jul 2024

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It’s déjà vu in Tokyo’s stock market as the Nikkei 225 rally shows signs of fizzling out. Global investors should know the drill quite well. Every three to five years, Tokyo shares surge on hopes that, this time, policymakers are serious about reforming an ageing, change-averse nation to rekindle innovation and boost productivity.

Each time, gravity reasserts itself. Once investors realise the rally has outpaced upgrades to underlying economic conditions, sobriety returns. Valuations drop back to earth.

Over the last two years, traders have arguably embraced, more than ever, the five most dangerous words in economics: this time things are different. The Nikkei boomed past 1989 highs, fuelling envy from New York to Seoul. The exuberance isn’t completely irrational. Much of it has been driven by moves to strengthen corporate governance since 2014.

Yet punters are realising the last decade was another lost one for Japan. The last three governments should have been cutting bureaucracy, modernising labour markets, catalysing a start-up boom, empowering women and reminding investment banks that Tokyo is still a centre of Asia’s financial universe.

The yawning gap between stock euphoria and the economy on which companies rely is impossible to dismiss. Japan is skirting recession again. The Bank of Japan has squandered its opportunity to get rates away from zero. And it’s dawned on global funds that Prime Minister Fumio Kishida’s 21 per cent approval rating makes Joe Biden seem almost popular.

This leaves Japan’s latest leader with near-zero odds of resurrecting the economic reform process this year.

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Also, traders are noticing the extent to which the external sector has turned against Japan. China is sputtering, taking Asia’s biggest economic engine out of the game. Europe is stumbling as Germany battles recession risks. In the United States, the Federal Reserve’s reluctance to cut interest rates is making the “higher for longer” era indefinite.

This last dynamic has the yen extending this year’s more than 14 per cent loss. Normally, this might cheer markets. Historically, weaker exchange rates pump up Japan Inc profits and, in turn, support the broader economy. Investors, though, are sensing that this time, something really is different: the weak yen is backfiring in alarming ways.

Yes, all 12 Japanese governments since the late 1990s have pursued a weak-yen policy. Imagine if the last three had focused more on raising Japan’s economic game than borrowing from Argentina’s playbook.

In 2012, Kishida’s Liberal Democratic Party (LDP) took power with bold and sweeping plans to slash red tape, reawaken the animal spirits that once captivated the globe and generate new economic energy from the ground up.

Sadly, Tokyo found it easier to rely on aggressive central bank easing than retooling things. Sure, former prime minister Shinzo Abe’s 2012-2020 tenure put some corporate governance wins on the board. Those steps to boost returns on equity and diversify boardrooms propelled the Nikkei to all-time highs.

An illuminated electronic stock board is displayed inside the Kabuto One building at dusk in Tokyo on June 27. Every three to five years, Tokyo shares surge on hopes that, this time, policymakers are serious about reforming the economy, yet each time, gravity reasserts itself. Photo: Bloomberg

The absence of bigger upgrades to level playing fields and alter incentive structures is now catching up with the market. Coupled with hyper-assertive Bank of Japan easing, the steps did little more than prove that “trickle-down economics” works no better than in the 1980s.

Hence the gravity troubles weighing on the market. The answer, of course, is for Kishida to announce an immediate and sharp pivot back to disrupting the economy.

That’s a tall task in the best of times. Just as it’s easier to fix a leaky roof when the sun is shining, it’s best to recalibrate growth engines when gross domestic product is expanding. But the economy is contracting while inflation is rising faster than wages. Japan is on the verge of stagflation.

Notably, Japan is enjoying a record tourism boom. This inbound surge – more than 25 million arrivals last year – is filling hotels, bullet trains, restaurants, shopping arcades and amusement parks. Yet GDP is shrinking. Without an ultra-weak yen, Japan would be even deeper in the red.

This isn’t where Kishida hoped the economy would be nearly 33 months into his premiership. He is paying the price for slow steps to incentivise greater innovation, increase productivity, narrow the gender wage gap and lure more international talent.

People take photos of Mount Fuji in Yamanashi prefecture, Japan, on June 19. According to data released by Japan National Tourism Organization last month, the number of foreign visitors traveling to Japan topped the three million mark for the third month in a row, an increase of 60 per cent from the same month of 2023. Photo: EPA-EFE

It’s painfully clear that the LDP’s rather modest reforms since 2012 have reached their expiration date with investors. There was nothing bold or innovative about Japan’s corporate upgrades. It was a package of moves Japan should have taken decades earlier, and it’s great it finally did. But what’s next?

A great place to start is committing to ending the weak-yen policy. Over the last quarter century – and especially since 2012 – an undervalued yen has deadened the urgency for Tokyo to raise its economic game and increase competitiveness.

Weak exchange rates took the onus off companies to restructure, disrupt and take big risks. That’s the irony of the corporate upgrades of the last decade. Though they gave investors greater dividends and capital gains, these tweaks haven’t reanimated Japan Inc’s inventiveness or boosted wages sustainably.

This would mean Japan raising its interest rates significantly for the first time in 17 years, a step that could shake markets across Asia. But normalising rates would signal that Japan is moving forward, not walking in place. That alone could boost economic and business confidence.

All the weak yen did, ultimately, was trigger a bull market in mediocrity. And the Nikkei bulls are catching on in ways that echo myriad past episodes. Déjà vu, indeed.

William Pesek is a Tokyo-based journalist and author of “Japanization: What the World Can Learn from Japan’s Lost Decades”