Should You Invest In Japan Now That Rates Have Risen?

Markets had long been expecting the Bank of Japan’s recent decision to end its policy of negative interest rates. Still, its March 19 announcement marked a turning point for a key economy and comes as Japan’s long-dormant stock market has been rocketing higher.

The last time the BOJ raised rates was 2007, the year Netflix NFLX first began streaming media and MySpace was 65 times more valuable than Facebook META.

While the rise in interest rates generated headlines, markets shrugged and continued with a recent pattern of Japanese stocks rising and the yen losing value. Following the central bank’s announcement, the yen rose above 150 against the US dollar, a multidecade low.

Despite recent success, Japan’s stock market has been peppered with false dawns, so the key question for investors is whether the rally in Japanese equities can be sustained. A rally one year is often followed by a slump the next year. China was one of the best-performing world markets in 2020 but has struggled since.

Japan’s Market and Currency Returns at a Glance

• The Morningstar Japan Index is up 16% in 2024.
• Over five years, the index is 96% higher.
• The Japanese stock markets last hit a record high in 1989.
• On March 6, 1987, the yen was 153 against the US dollar. It is currently 151 against the dollar.

Japan’s “Lost Decades”

Following the boom years of the 1980s, when Japan’s stock and property markets hit record highs, the country has suffered “lost decades” of low growth and deflation. The BOJ’s negative interest-rate policy was instituted in 2016 in an attempt to “reinflate” the economy. After many years, it appears to have worked, because the domestic economy has some modest inflation, helped by the country’s first pay raises in decades. Japanese companies have been able to increase prices as well, which has helped profitability.

Japan was not unusual in doing this. After the 2008 financial crisis, central banks cut interest rates to stimulate economies and encourage borrowing by consumers and lending by banks. The European Central Bank’s deposit rates were negative from 2014 to 2022, and the Federal Reserve had the federal-funds rate close to zero in 2020.

In the West, these policies were effective in encouraging asset price inflation in property, bond, and stock markets. For a while, it seemed as if this could be achieved without introducing inflation, an expected consequence of quantitative easing. The covid-19 pandemic, Russia’s invasion of Ukraine, and other factors brought this complacency to an end, and central banks scrambled to hike rates to suppress rising prices.

Japan’s malaise has been more extreme and its economic slump has been more protracted than in other developed countries. For many years, it felt like the negative interest-rate policy was not working because inflation remained elusive. People didn’t want to save (or invest), nor did they expect pay raises. After a period of high inflation, falling prices would seem desirable, but deflation can also be damaging. Consumers stop spending on nonessentials because they expect prices to fall. Saving is also perceived to be ineffective because interest rates are so low. Companies make less money because they can’t raise their prices. Workers can’t bargain for higher wages because of those falling prices. Employers may consider cutting jobs because profits are weakening, creating a spiral that can lead to recession.

Weak Yen, Strong Exports. Will That Change?

A key factor is Japan’s weak currency, which makes its exports (robotics, cars, computer games, and so on) much cheaper for foreign buyers. But investors who are bearish about Japan expect interest-rate hikes to end the era of the weaker yen. Rising interest rates make a currency more appealing to investors. US government debt has always been attractive to overseas investors, and the federal-funds rate being at 5.25% offers a “risk-free” yield above inflation. Morningstar’s Fernando Luque has looked at this in more detail.

The yen recovery hasn’t happened yet, mainly because markets don’t think the BOJ is embarking on a tightening cycle that will harmonize Japanese and Western interest rates. For comparison, the cost of borrowing in Japan is between 0.0% and 0.1%, while it’s 5.25% in the UK and 4.5% in the eurozone.

Morningstar analyst Lorraine Tan argues: “We think the BOJ will be prudent when raising rates further, given that the Japanese government bears the risk of paying higher interest costs. Also, with more than 80% of borrowers holding floating-rate debt, large moves will likely be avoided. While interest rates are rising, they remain low. We do not expect any impact on loan demand, and see loan growth maintained at a low-single-digit pace.”

Tan believes a rate increase will help banks, which should “enjoy stronger earnings growth over the next three years, with returns on equity increasing.” When interest rates rise, banks earn a higher net interest margin—the difference between money paid out on deposits and money made on loans.

Should You Invest in Japan Now That Rates Have Risen?

But that’s all very domestic. Foreign investors will want to know whether they should change their view of Japan and its markets.

“We think the main reason overseas investors can be positive about Japan in the long term is that the return of inflation will boost spending and drive capital reinvestment,” Tan says. “Decadeslong deflation discouraged Japanese companies from reinvesting domestically and saw house prices slip. Now that there appears to be some prospect of rising prices, we hope this will lead to a sustained changed mindset toward domestic investment, leading to increased consumption.”

Tan continues: “However, should the yen appreciate as quickly as it fell, some of these drivers could be diminished. We think overseas investors should be hedged in that regard, as a strengthening yen should help counter a possible slip in share prices.”

In a recent seminar, Pictet Japan fund manager Sam Perry argued the link between a stronger yen and weaker equity returns was not grounded in reality. According to him, there is also no sense that, domestically, Japan is in bubble territory. “Strange things are happening in small parts of the market,” he said, but overall, Japanese retail investors are not gripped by trading frenzy—which is often a sign a market is about to collapse.

Are Japanese Bonds on the Menu Again?

But the most obvious impact will be on fixed income. “The BOJ’s March 19 policy changes, while largely anticipated, should have minimal immediate market impact,” says Tomoyo Masanao, co-head of Asia-Pacific portfolio management and co-head of Pimco Japan. “However, the medium- to long-term implications could be significant, as the potential scale of the policy changes may be more than the financial markets currently anticipate.”

Masanao continues: “For investors, the Japanese bond markets should start offering a higher risk premium and modestly higher yields in response to the BOJ’s continued policy adjustments and the transition of government bonds back to market forces. As the market digests the new and evolving policy stance, there will be tactical opportunities for active managers to capitalize on the inefficiencies in the Japanese bond and interest rate swap markets during this period of increased volatility.”

As such, investors, who are wary of the market for obvious reasons, may be drawn back into Japanese bonds as yields improve.