Japanese stocks see best first-half in a decade. Here’s what it will take for the rally to continue.

It’s the latest milestone in what has been a banner year so far for Japanese stocks as the typically staid Japanese equity market sprang back to life. The last time Japanese stocks were rallying like this, former Prime Minister Shinzo Abe had just been elected in 2012 and was promising an economic agenda anchored in ultra-loose monetary policy, fiscal stimulus and structural reform.

“For the longest time, Japan was seen as a dog. It’s always been seen as a market that’s going to lag,” said Omar Aguilar, chief investment officer at Schwab Asset Management, which manages mutual funds and exchange-traded funds with exposure to global equities, including Japan. 

The rally has carried Japanese stocks to their highest levels in decades. Both the TOPIX and NIKKE reached highs unseen since the first half of 1990 on June 16, when the Topix closed at 2,300.36, and the Nikkei closed at 33706.08. That high is notable since it marks the peak of the Japanese asset bubble in stocks and real-estate which collapsed shortly after, helping to usher in Japan’s “lost decade.”

While the weak yen is seen as most important driver of Japanese stocks’ performance, there are other factors contributing to the rally.

Japan has enjoyed relatively low inflation compared with the U.S. and Europe, helping to make Japanese assets into a haven from rising prices around the world in the wake of the pandemic and the Ukraine war.

“People are looking for places where there’s not a big inflation problem,” Aguilar said.  

Japanese stocks have also benefited from the star power of the Oracle of Omaha.

Earlier this year, Warren Buffett upped his investment in five Japanese trading houses via a subsidiary of his Berkshire Hathaway Inc.
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+1.29%

BRK.B,
+1.45%
and proclaimed that he is bullish on Japanese stocks. Berkshire now has more exposure to Japanese equities than any country outside the U.S.

Whether the bull run can continue will likely depend on how Japanese monetary authorities react to the reemergence of inflation and economic growth in that country.

Inflation has finally started to pick up in Japan for the first time in decades, although it remains tame relative to the rest of the world, according to Marvin Loh, a senior global strategist at State Street, during an interview with MarketWatch.

Data released Friday showed the Tokyo Consumer Price Index eased to 3.1% in June on a year-over-year basis, down from 3.2% during the prior month. Earlier this year, core prices hit their highest level in more than four decades, official data show.

Accelerating inflation could pressure the Bank of Japan’s new Gov. Kazuo Ueda to consider further loosening, or abandoning, Japan’s easy monetary policy, a critical anchor for the yen that has helped to keep it week vs. the U.S. dollar.

Investors got a taste of this last year, when the BoJ eased its grip on Japanese government bond yields. Since then, economists from major global investment banks have anticipated that the BoJ would continue to move away from its ultra-loose monetary policy, but they have been repeatedly disappointed.

So far, Ueda has offered no hint of an imminent shift in policy. During a summit for central bankers in Sintra, Portugal earlier this week, Ueda deadpanned that it could take decades for the lagged effects of Japan’s monetary policy to manifest, a remark that Loh and others interpreted as an almost comical repudiation of economists’ predictions that a major shift could be just around the corner.

One risk to Japanese stocks and the yen is that whenever the BoJ does decide to make a change, it likely won’t warn investors first. The BoJ is more comfortable taking markets by surprise, unlike the Federal Reserve, which prefers to telegraph its plans in advance, usually via Fed officials public commentary.

“The Bank of Japan likes to surprise. When they widened the band on yield curve control last year, it was on the heels of the BoJ saying we’re not looking to change anything,” he added.

While many hope the bull run in Japanese stocks will continue, a team of economists at Capital Economics said in a research note shared with clients and MarketWatch earlier this week that the trend of Japanese equity-market outperformance could soon come to an end.

As the undervalued yen moves higher, “we expect yield differentials versus the U.S. to shift back in its favor, as the Fed concludes its tightening cycle in the next month or so and investors’ focus switches to the upcoming easing,” the team said.

The Japanese yen
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was trading just north of 144 to the U.S. dollar on Friday. Ueda has said Japanese authorities could move to directly intervene to support the currency if it continues to fall, like they did last year as the yen tumbled to its lowest level against the dollar in more than three decades.