China’s economic loss is not necessarily Japan’s gain

Tokyo has overtaken Shanghai to become Asia’s largest stock exchange, driven by investors keen to get exposure to the region while mitigating risks in China
However, China is an important source of revenue for Japanese firms in crucial industries, which would be hard hit by a deeper downturn in the world’s second-largest economy

Nicholas Spiro

Published: 5:30am, 26 Jan 2024

Why you can trust SCMP

It looks like 2024 is shaping up to be the year of milestones in Asia’s equity markets. On January 23, India’s stock market capitalisation surpassed Hong Kong’s in US dollar terms for the first time, making Asia’s third-largest economy the world’s fourth-biggest equity market.

Earlier this month, the Hang Seng Index again fell below the symbolically important level at which it stood on July 1, 1997, when the city returned to China’s rule. Since its peak in January 2018, the Hang Seng has lost 50 per cent. India’s benchmark BSE Sensex index, by contrast, has soared 200 per cent since February 2016.

However, the defining moment came on January 11 when the market capitalisation of the Tokyo Stock Exchange overtook that of the Shanghai bourse, allowing Tokyo to regain its position as Asia’s largest stock exchange.

The starkly diverging fortunes of the region’s two biggest equity markets are redrawing the investment landscape in Asia. By the end of last week, a staggering US$6.3 trillion – about the current market capitalisation of the Shanghai bourse – had been wiped off the value of Chinese and Hong Kong shares since early 2021, data from Bloomberg shows.

Sentiment towards China is so bleak that investors are at a loss as to what needs to happen – both domestically and externally – for a meaningful and durable rally to take hold. Even the prospect of a package of more forceful measures to shore up the stock market has been met with scepticism given the deep-seated structural problems in China’s economy and the increasing appeal of other markets in the region.

According to the results of Bank of America’s latest Asia fund manager survey, published on January 16, only 4 per cent of respondents expected a stronger Chinese economy this year, while a net 20 per cent were underweight Chinese shares, far and away the biggest underweight position in the region.

02:31

China GDP: Beijing’s long to-do list to boost its economy in 2024

Japan’s equity market, on the other hand, is going from strength to strength. The Nikkei 225 index is up nearly 40 per cent since the start of 2023, leaving it only 7 per cent below the level at which it stood in December 1989, just before the bursting of Japan’s colossal asset bubble led to decades of deflation and stagnation.

Global funds are piling into Japanese shares, enticed by promising signs deflation has been banished. Persistently ultra-loose monetary policy, the weak yen and corporate governance reforms have also buoyed sentiment. A net 59 per cent of respondents in the Bank of America survey were overweight Japanese stocks.

One of the big themes in Asian stock markets – and one of the reasons Japan is popular among international investors – is the geopolitical reshaping of supply chains and the growing demand for Asian investment products that exclude China.

Bank of America says Japanese shares benefit from “ABC” or “anywhere but China” global liquidity, while Morgan Stanley says Japan is in a stronger position due to “multipolar world dynamics” and the country’s role as “a major security ally of the US with substantial technological leadership in key sectors” and the ability “to benefit from supply chain on-shoring”. Put another way, China’s loss is Japan’s gain.

03:16

Biden and Kishida pledge to strengthen US-Japan ties as a counter to China

Not so fast. First, the main reason Japan’s stock market is generating so much interest is because it has been under-owned and underappreciated by foreign investors for such a long time. Bank of America notes that Japan constitutes only 5.5 per cent of the MSCI All-Country World Index – one of the leading gauges of global stocks – compared with almost 45 per cent just before the 1980s bubble popped.

Moreover, while Japanese stocks are approaching their bubble-era peak, they are still incredibly cheap compared to 1989, increasing the appeal of a turnaround story driven by reflation and governance reforms.

Why Japan’s hotels are all the rage among investors and tourists

Second, the “Asia ex-China” investment strategy needs to be treated with caution. Although Japan has emerged as an attractive market that is deep and liquid enough for global investors to maintain their exposure to Asia while mitigating risks in China, it does not fully insulate them against China’s woes.

A prolonged and deeper downturn in China would be harmful to Japanese stocks, especially if it coincided with a US recession. Although other Asian economies have stronger trade links to China, the world’s second-largest economy – which is Japan’s biggest trading partner – is an important source of revenue for Japanese firms in several crucial industries.

Workers assemble a vehicle at a factory in Ota, Gunma prefecture, Japan, on December 14 last year. For many Japanese companies, China is their most important market or among their top three. Photo: Bloomberg

According to data from Morgan Stanley, China accounts for 20-24 per cent of revenue for companies in the factory automation, electronic components, and household and care products industries. Furthermore, it comprises 18 per cent of revenue for firms in the strategically important semiconductor sector, the segment of Japan’s equity market in which the Bank of America survey respondents have the biggest overweight position.

Tellingly, the findings of another survey published earlier this month by the Japanese Chamber of Commerce and Industry in China revealed that more than half of Japanese firms polled said China was either their most important market or among their top three.

Geopolitical tensions are unquestionably working in Japanese stocks’ favour. But the “Asia ex-China” argument only goes so far, especially in markets and sectors that are reliant on Chinese growth. At a time when Japan’s nascent inflation is vulnerable to economic headwinds – particularly a premature end to the Bank of Japan’s ultra-loose monetary policy – a sharper slowdown in China would augur badly for Asia’s largest stock exchange.

Nicholas Spiro is a partner at Lauressa Advisory