Nathan Sweeney's view on: Why we’re seeing opportunities in Japan and smaller companies

A 25-year battle with deflation, and concerns about corporate governance, are among the reasons that Japan has long been regarded by many investors as the land of false dawns, rather than the land of the rising sun.

That changed last year, when Japanese equities performed strongly, with the Nikkei 225 gaining 28%. We believe at current valuations Japanese equities continue to look attractive and they represent an overweight position in our portfolios.

Japan has experienced long periods of deflation over the past 25 years, but last year its inflation rate rose to over 4%, as companies passed on higher costs.

Inflation has since eased to a more manageable level and the Bank of Japan says the prospects for the world’s third-largest economy to begin to sustain its 2% inflation target are “gradually heightening”.

This is significant because a degree of inflation is likely to help to drive wage growth, something long missing in the Japanese economy, and higher salaries should then help to support a growing economy.

What is also important for investors is that the latest corporate reforms, which were introduced in April 2022, seem to be having a meaningful impact. Historically, Japanese corporate culture has not been seen as shareholder-friendly, which has deterred investors.

Significant pressure is now being put on the management of Japanese companies, accused by critics of viewing shareholders as the enemy, to use capital more effectively and increase profitability. The Tokyo stock exchange has warned that companies that do not comply with the new corporate governance rules face the prospect of being delisted. We believe that these measures are starting to make an impact and unlock the value in Japanese companies.

We have also seen a weakening in the Yen, which makes Japanese exports more attractive, providing another boost for the nation’s businesses.

Japanese companies look attractively valued relative to their US counterparts. The forward P/E multiple on Tokyo’s Topix Index is just under 14.5x, while the S&P 500 is on 20.5x. With expectations rising that the economy will manage to maintain a healthy level of inflation, and corporate reforms looking like they are beginning to take root, we believe Japanese equities represent an attractive opportunity.

Small and mid-caps may be set to shine

We also see interesting potential in small and mid-cap companies in developed markets. Smaller companies sold off aggressively in 2022 and remained out of favour last year because of economic uncertainty and rising interest rates, which tend to hit smaller companies harder than their larger counterparts.

However, with US and UK central bankers signalling a first interest rate cut this summer and the European Central Bank likely to follow suit, we believe the stage is set for a more supportive environment for smaller companies. At current depressed valuations, we believe they offer strong long-term growth potential.

Government bonds also looking attractive

After a challenging period for fixed income, we see attractive potential for capital appreciation by government bonds. We expect the interest paid by bonds to start to look increasingly appealing for investors as rates on cash deposits begin to fall. As a consequence, we have moved to an overweight position in government bonds.

Outlook

Considerable risks remain, not least from geopolitical uncertainty focused on Russia and the Middle East. In addition, we have elections around the world, with the presidential vote in the US likely to have significant global implications. Economic data is also likely to ebb and flow, which we expect to lead to some degree of further volatility. Overall though, we believe the outlook is growing more positive and that investors holding multi-asset portfolios are likely to be well positioned to reap the benefits of improving sentiment.

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‍Capital is at risk. The value and income from investments can go down as well as up and are not guaranteed. An investor may get back significantly less than they invest. Past performance is not a reliable indicator of current or future performance and should not be the sole factor considered when selecting funds.

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