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TOKYO — Japanese stocks are having quite a moment as waves of foreign capital drive the benchmark Nikkei index to 30-year highs.

The common explanation for this year’s 30% gain is that a decade of efforts to tighten corporate governance are finally gaining traction.

There are signs indeed that companies from Canon to Toshiba to Citizen Watch are showing signs of actually listening to shareholders’ demands.

Add the fact that Japan Inc has been comparatively cheap valuation-wise during that decade and it’s not hard to understand why Tokyo shares are on a winning streak. Just ask Warren Buffett, whose 2020 bet in five Japanese trading houses is paying off handsomely.

Yet some sobriety is warranted, lest punters allow irrational exuberance to get the better of them once again. The question is whether government reforms are keeping sufficient pace with the bulls racing around Tokyo. The answer: not by a long shot.

An argument can be made that Japan Inc’s return to favor is as much a reflection of global events and domestic liquidity levels as bets on a renaissance in corporate attitudes.

Take the Bank of Japan, which is the ultimate outlier among top monetary authorities. As the US Federal Reserve, European Central Bank and Bank of England hit the brakes, the BOJ continues to gun the monetary engine.

For now, “the economic backdrop remains fragile,” says Stefan Angrick, senior economist at Moody’s Analytics. “Although Japan’s belated recovery has found some better footing, GDP is still below its pre-pandemic peak. Industrial production and exports have struggled as the global economy has flirted with recession.”

From a liquidity-differential standpoint, Japanese stocks — long undervalued by global investors — are gaining converts. Japan, meantime, looks like a welcome haven from the US-China trade tensions that are unnerving global markets.

Trouble is, it’s highly unclear that the underlying state of Japan’s economy warrants continued rapid stock gains. It follows that Japan, circa 2023, is a more complicated calculation than meets the eye.

In a nutshell, the market remains vulnerable to a macroeconomic backdrop less conducive to surging shares than many punters might realize.

Not to dismiss the ways in which corporate boardrooms are modernizing. They are indeed. The common analysis — and frankly the lazy one — is that the supposed reform Big Bang that then-prime Minister Shinzo Abe launched in 2013 deserves all the credit.

The late Abe deserves certain kudos, of course. In 2014, his Liberal Democratic Party enacted a UK-like stewardship code to encourage companies to give shareholders a bigger voice. The LDP prodded companies to add more outside directors, increase returns on equity and boost dividends.

Credit where it’s due, those upgrades are playing a role in today’s Nikkei rally. But the bigger catalyst here is China.

It was just before Abe took power in 2013 that China surpassed Japan in gross domestic product (GDP) terms. And it was around that time that Japan Inc chieftains realized that circling the wagons was no longer an option.

A similar pattern played out a decade earlier, when Japanese banks finally addressed the bad loan hangover from the 1990s.

Pundits rushed to credit then-prime minister Junichiro Koizumi for fixing the mess. In reality, it was the realization that China was remaking the financial playing field in Asia that sparked reform — and the urgency for Japan to get back in shape.

In both the early 2000s and early 2010s, there was nothing new or innovative about policy shifts under Koizumi and Abe. Other than Koizumi’s bold privatization of Japan Post, most steps by their governments were obvious ones Tokyo should’ve taken decades earlier.

This gets us back to today’s stock surge. At some point, stocks long deemed as “cheap” will cease to be considered as such.

As the market becomes less cheap, investors will begin scrutinizing a macroeconomic backdrop that’s far less vibrant than to be expected after 10 years of so-called “Abenomics.”

Already, “the gains of the past month have taken Japanese equities from cheap to neutral,” says strategist Luca Paolini at Pictet Asset Management.

When Fumio Kishida rose to the premiership in October 2021, a year after Abe resigned, he called for a “new capitalism.” Kishida did so cautiously, knowing that the still-powerful Abe was looking over his shoulder.

The thrust of Kishida’s plan was to increase innovation and do a better job of spreading the benefits of growth. It was, at its core, an admission that Abenomics was less a Big Bang than a series of modest pops.

The more Kishida talked of plans to loosen labor markets, reduce bureaucracy, increase innovation and productivity, empower women and restore Tokyo’s status as a global financial center, the more he was admitting that Abe hadn’t got the job done during his nearly eight-year reign.

It was the worst-kept secret in Nagatacho, Japan’s Capitol Hill, that Abe was seething at the implication — and mulling a return to power for a third time (he was assassinated in July 2022). Now, Kishida is mulling calling an early snap election to consolidate power.

Chatter that Kishida might announce an election this week didn’t pan out. But with his approval rating in the mid-40s, Kishida could call an election at any moment.

Pundits agree Kishida’s sudden rediscovery of economic reform buttresses the early election talk. In recent days, Kishida’s government unveiled a wide-ranging package of measures to reverse a falling birthrate in the developed nation with the globe’s worst debt burden. The plan is to double childcare expenditures.

Here, too, when Kishida says “the low birthrate is a massive problem that concerns our country’s society and entire economy and can’t be put off,” it’s a tacit reminder of the to-do lost Abe’s 2012-2022 reign ignored.

This burst in childcare spending comes as Kishida is also angling to hike military spending by more than 50% over five years to around 43 trillion yen ($307 billion) to keep pace with China. The daunting bill for all these outlays will entail tax increases, including on Japan’s biggest corporations.

Another complicating factor for Nikkei bulls is that the BOJ’s decades-long quantitative easing (QE) policy is on borrowed time. Though new BOJ governor Kazuo Ueda’s team demurred this week, the clock is ticking as the worst inflation in decades becomes more ingrained.

At just over 4%, Japan’s inflation rate has been well above the 2% target. The BOJ hasn’t ended QE in part because upward price pressures reflect rising import costs of energy and raw materials, not strong demand trends. These supply-side price pressures are best addressed with steps to increase competitiveness.

Ueda’s team is in do-no-harm mode with regard to the macroeconomic scene and corporate profits. In the past, premature BOJ tightening derailed economic recoveries. One example: two rate hikes in the 2006-2007 period that had to be reversed when national growth faltered.

The legacy of such episodes might prevent Ueda from taking steps to keep inflation from embedding itself in the economy. At the same time, this year’s 3.8% average wage gain — the highest since the early 1990s — is less than the inflation rate.

“This,” argues economist Carlos Casanova at Union Bancaire Privée, “puts a damper on domestic consumption via negative real wage growth. Therefore, the BOJ will be in no rush to tweak settings.”

Of course, it’s more complicated than that. As Casanova explains, Ueda’s team at the BOJ has “flagged that a shift in corporate price-setting behavior was showing changes that could work to push up inflation, suggesting the economy was making steady progress toward hitting” preferred pace of price gains.

Yet the US Fed’s failure to act quicker to tame prices is a cautionary tale — and a warning against BOJ complacency.

As Kelvin Wong, analyst at Oanda, sees it, “overall, the improving economic backdrop in Japan with accelerating sticky inflation coupled with a buoyant stock market that is supported by foreign net inflows has opened a window of opportunity for BOJ to normalize its ultra-easy monetary policy.”

Wong notes that it would mean “at least via a further widening of the yield curve control band in the first step, perhaps in July when it publishes its latest quarterly outlook report that comes with its latest projections of inflation and economic growth trend.”

For now, though, the BOJ’s ultra-loose policies are a giant tailwind for stocks.

Strategist Yunosuke Ikeda at Nomura Holdings adds that “we see the recent strength of Japanese equities as arising from a combination of an accumulation of longer-term bullish stories, the evaporation of some short-term worries, and buying by nonresident investors.”

Goldman Sachs strategist Kazunori Tatebe notes that recent corporate earnings trends provide “additional fuel for investors’ bullish stance on Japanese stocks, providing some reassurance on the earnings outlook.”

Low price-to-book ratios continue to turn heads Tokyo’s way, Tatebe argues. “If progress is made in accordance with investor expectations,” Tatebe says, “Japanese stocks could see a prolonged advance over the medium term, and we continue to see risk to the upside.”

Nicholas Smith, strategist at CLSA Japan, agrees. “Japan went from bubble to anti-bubble. Its superior earnings-per-share growth and bargain-basement valuations over the last decade went unnoticed” into earlier this year.

That, Smith notes, “prompted massive buybacks that cash-bloated Japan can easily afford. That, in turn, woke up foreign investors who remain heavily underweight.”

Yet there is a risk that the BOJ might stop acting like a 24/7 no-limit ATM for global investors, which would be a devastating blow to Nikkei bulls.

“Japan is in its own virtuous economic cycle, with GDP growing solidly thanks to healthy domestic demand,” says Paolini at Pictet Asset Management. But, he adds, “the Bank of Japan might, however, start to temper this if, as we expect, it winds up its ultra-accommodative monetary stance.”

As such, “Japan is the only developed government bond market in which we hold an underweight,” Paolini says.

Stocks are another story, of course, as the bulls run Tokyo’s way from all directions. For now, at least, as the BOJ keeps filling the proverbial punchbowl as peers drain liquidity. The question is whether government upgrades catch up with enthusiasm about Japanese shares – and that’s anyone’s guess.

Follow William Pesek on Twitter at @WilliamPesek

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