Unveiling the Japanese Stock Market: What's Driving the Surge This Year

This year, Japan's market has hit historic milestones. The Nikkei Index, Japan's premier stock market indicator, has shattered several records, reaching heights not seen in 34 years and crossing the 41,000-point threshold for the first time. As of today, the Nikkei 225 index has risen nearly 15% year-to-date, ranking among the top-performing global stock indices.

The famous Warren Buffett has always regarded Japan as one of the best destinations to invest in, as he continued to increase his bets on the Japanese stock market since last April. Alongside Buffett, Wall Street giants like Goldman Sachs are eyeing Japan, favoring energy and Japanese stocks amid U.S. tech uncertainties and valuing Japan's market reforms and attractive valuations. Morgan Stanley, collaborating with Mitsubishi UFJ, has also deployed a large Tokyo research team to major Asian financial centers, showcasing Japan's resurgent economy to investors worldwide.

The Nippon ISA (NISA) allows people living in Japan to invest in the stock market without paying taxes on their capital gains or dividends. Initially launched in 2014, NISA aims to turn the trillions of yen held in cash by households into investments in stock markets.

Prime Minister Fumio Kishida's push for the new NISA (Nippon Individual Savings Account) officially began in 2024, reinforcing the country's efforts to encourage a shift from savings to investments in the equities market. Compared with the original NISA, the Tsumitate Quota (formerly the Tsumitate NISA) and the Growth Quota (formerly the General NISA) have been expanded to 3.6 million yen, and the tax-free period has been eliminated, allowing investors to buy and sell repeatedly within a certain amount without paying capital gains tax.

In addition, the investment scope of the new NISA has been expanded to include stocks and stock-type investment trusts, and both dividends and gains from selling stocks can enjoy tax-free treatment. The implementation of the new NISA is significant for the Japanese stock market, as it is expected to effectively stimulate the enthusiasm of individual investors to participate in the stock market, open up a lot of potential funds flowing into the stock market, and further promote stock market growth.

According to data released by the Tokyo Stock Exchange, the new NISA program is estimated to bring in 6 trillion worth of capital from individual investors in 2024, which in turn contributed to the dramatic surge of Nikkei this year.

The Tokyo Stock Exchange in March 2023 asked companies with P/B ratios below 1.0 to disclose specific policies and initiatives to lift their value as it sought to raise management awareness of capital costs and stock prices. The directive, although not binding, is also seen as a message to draw more interest from overseas investors.

The request, hailed by investors as a remedy to Japan's unusually high number of chronically undervalued stocks, led to a wave of share buybacks and dividend hikes, as many Japanese companies started to turn their focus on shareholder returns.

In 2023, the total amount of stock buybacks by Japanese listed companies reached approximately 9.6 trillion yen, reaching a new high for two consecutive years. Amid the rising stock prices, the current trend of buybacks remains very active. The effort to increase shareholder returns was once a topic of great interest to investors in the US stock market, and now the Japanese stock market may also produce similar results, boosting stock prices.

The yen continued to weaken against the dollar in 2024, even as Japan started to exit its prolonged ultra-loose monetary policy. The USD/JPY exchange rate hit a fresh 33-year high of 154 in April, amid a broadly stronger dollar underpinned by economic data that has pushed out the expected timing of the first Fed rate cut to September from June and escalating tensions in the Middle East.

The yen depreciation so far this year has increased the income earned by multinational corporations overseas and strengthened the price competitiveness of Japanese-manufactured products sold abroad, thereby driving strong growth in total company revenue. Automakers and consumer electronics companies who mainly earn their revenue abroad have been the main beneficiaries of a weakened yen, with their stocks outperforming the overall market so far this year.

As economic and geopolitical woes spur an exodus of investors from China, many have been redirecting money into Japan, boosting the benchmark Nikkei index to its all-time high. Investors who have historically owned Chinese stocks but are now keeping a distance for fear of U.S. sanctions see owning a Japanese firm that either sells to China or is based there as the more politically palatable option.

About $6.59 billion has flowed out of China offshore funds since April 2023, while Japanese offshore funds received $6.3 billion worth of inflows in February 2024, adding to inflows of $7.84 billion last year, according to LSEG data.

Unlike the dominance of banks and utilities during the bubble economy of 1989, as of early 2024, technology companies make up approximately 50% of the weight in the Nikkei Index. This is partly a result of the rise of Japanese technology stocks and semiconductor sectors amid the continued AI wave, and also means that the current Nikkei 225 Index is expected to benefit more from investment opportunities brought about by the strong demand for AI worldwide. Chip-related companies such as Advantest and Tokyo Electron are expected to further boost the index.

While the Nikkei has pulled back from its historical high in recent weeks amid strong US economic data and rising geopolitical tensions in the Middle East, the fundamental reasons behind its surge this year are most likely to continue in the long run.

As Japan emerges from decades-long deflation, major foreign institutional investors would further raise their bets on Japanese equities. In the meantime, with the Federal Reserve set to cut interest rates later this year, the interest rate differential between the United States and Japan would most likely decrease, leading to yen appreciation in the long term. Foreign investors could not only benefit from the surge in the Nikkei index, but also benefit from the appreciation of yen.

Therefore, it might be a great time for foreign investors to invest in blue chip companies that are listed on the Prime section of the Tokyo Stock Exchange right now.

Among the top ten best-performing stocks in Nikkei this year, two are the well-known major trading houses in Warren Buffett's portfolio, specifically Mitsubishi and Mitsui, which have seen their stock prices soar by 52.74% and 33.28% since 2024, outperforming the Nikkei Index's 15.00%.

In addition to the two trading companies mentioned above, some tech-driven companies are also worthy of investors' attention under the influence of the global AI wave, such as the global semiconductor equipment and materials giant Disco, Japan's largest semiconductor manufacturing equipment supplier Tokyo Electron, and automotive giant Toyota. These companies have also achieved impressive gains this year, with increases of 52.20%, 47.65%, and 38.85%.

Beyond the well-known five major trading firms and the 'Seven Samurai' of Japan, there are many other companies in the Japanese market that warrant attention. These include Hitachi, Denso, Tokio Marine, Softbank, and SMFG.