Japan’s Zombie-Infested Stock Market

Japan’s stock market is experiencing irrational exuberance due to factors such as the high odds of a recession, China’s economic slowdown, and the Bank of Japan’s lack of confidence in the economy’s readiness for quantitative easing.

However, a new concern is the rise of zombie companies, which have risen from 30% to an 11-year high of around 250,000, or 17% of the total number of unsound companies. The pandemic played a role in this zombification, with the number of zombie firms increasing by nearly a third between 2021 and 2022.

The pandemic also exposed the unhealthy amount of skinny-dipping among Japan’s corporate chieftains, as seen in Warren Buffett’s famous observation that “only when the tide goes out do you discover who’s been swimming naked.” The Bank of Japan’s liquidity programs, particularly under Abe’s watch, helped keep the tide from going out, with Haruhiko Kuroda being appointed as BOJ governor in 2013. Kuroda quickly expanded the BOJ’s balance sheet to the point where it topped Japan’s US$4.7 trillion economy within five years. However, the BOJ’s hyper-aggressive policies have backfired in several ways.

Japan’s economy has been hit hard by the yen’s plunge, leading to high energy and food costs. The government’s prioritization of monetary easing over reforms has not convinced CEOs to raise wages, resulting in inflation rising faster than wages. The BOJ’s largesse has taken the responsibility of restructuring, innovation, and risk-taking off companies, who have largely relied on free cash from the BOJ. This has led to a rally in Japanese stocks, with the Nikkei trading near 34-year highs. The rally is partly due to Japan’s safe-haven status and efforts to strengthen corporate governance over the last decade.

The ruling Liberal Democratic Party passed a UK-like stewardship code in 2014 to increase returns on investment and encouraged companies to increase returns on equity. The Tokyo Stock Exchange (TSE) is now releasing a list of companies planning to boost capital efficiency to attract more overseas investors. Japan is entering a transformational decade, with structural change driven by new government mandates and the TSE optimizing capital allocation. The Nikkei 225 may reach 40,000 by mid-2024. However, it remains to be seen whether Japan has changed its ways in response to global funds’ excitement.

Japan’s tech stocks have been under scrutiny due to the BOJ’s failure to offer a plan for stepping away from quantitative easing (QE). Last year, the Nikkei 225 and Topix indexes surged more than 25%, and the Nikkei is up another 8% so far this year. The BOJ’s failure to “taper” or offer a plan for stepping away from QE has led to the Nikkei bulls running faster. Analysts believe that April is the earliest time the BOJ would consider raising interest rates and ending yield curve control.

The BOJ will confirm the sustainability of wages and exit negative interest rate policy in April, followed by gradual rate hikes in the second half of 2024. Bank of America compared the Japan rally to the April-June 2023 Nikkei surge, noting similarities with last year’s rally driven by union wage hikes. However, SMBC Nikko’s chief equity strategist, Yasuda, argues that this year’s bullishness among foreign investors has greater momentum as funds play a “long game.”

Japan’s economy has been struggling due to high stock valuations and a lack of corporate governance adjustments, according to Nikkei bulls. The country’s successor, Yoshihide Suga, has not implemented any significant upgrades since September 2021, and the question remains whether these changes were game-changers. The US stock valuations are also considered too high, with a price-to-earnings ratio of about 19 for the S&P 500. China is considering a $278 billion stock rescue package and cutting the reserve requirement ratio for banks to help stabilize a $6 trillion stock rout.

Foreign investors are reducing their risk exposure to China and harboring bearish expectations for business conditions. Japan’s situation is further complicated by the zombie factor, as the BOJ has been working on perfecting its QE program since 2001, particularly after the 2008 “Lehman shock” and the 2013 monetary gas crisis.

The Japanese Bank of Japan (BOJ) has been left with an unpalatable choice to throttle back monetary support and tolerate increased bankruptcies and higher unemployment. This has led to a doubt in the BOJ’s decision to hike rates as soon as April.

Economists are mixed on the BOJ’s confidence in withdrawing liquidity, with Takeshi Yamaguchi, chief economist at Morgan Stanley MUFG, stating that policymakers remain “cautious” about the broadness and extent of the wage-price cycle. Bankruptcies are surging at a time when Japan may be in recession, and any further increase in corporate zombies could further depress wages.

The 2024 outlook for wage gains and consumption boom may not be favorable due to a disorganized government, political chaos, and the ongoing economic issues. The Nikkei bulls may have more reason to hide due to the tumultuous premiership and corporate zombie factor.

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