Approaching 40,000 points! Japan's PMI sees the largest contraction in 3 years, but Japanese stocks continue to hit new highs.

Japan's economy is slowing down, the manufacturing industry's prospects continue to deteriorate, yet the stock market is soaring against the odds. What is driving this bull market in Japanese stocks?

On March 1st, Japanese stocks surged again, with the Nikkei 225 index rising by 2.1% to 39,990.23 points, hitting a new historical high and approaching the 40,000-point mark. The TOPIX index in Japan also rose by 1.1% to 2,709.42 points, nearing its historical peak. Year-to-date, the Nikkei 225 index has risen by nearly 20%, and the TOPIX index has increased by around 14%.

However, while Japanese stocks continue to break new historical highs, a key indicator of Japan's manufacturing activity has dropped to its lowest level in over three years, indicating a deteriorating business environment in Japan.

On March 1st, a report from S&P Global stated that Japan's February Jibun Manufacturing PMI fell from 48 to 47.2, the lowest level since August 2020, marking the ninth consecutive month that the index has been below the 50 threshold.

S&P Global analyst Usamah Bhatti pointed out in the report that a significant decline in new orders has led to a sharp slowdown in production activities:

"Japan's private sector economy showed slight improvement at the beginning of the year, but deteriorated again in February, with business activities generally stagnating. Business optimism hit a low point since January 2023, reflecting a decline in optimism about future output."

Moody's analysts wrote in the report that the outlook for Japan's manufacturing industry seems "extremely challenging." The institution emphasized that global demand for Japanese goods has significantly slowed down in recent months, while weak domestic demand in Japan has led to a decline in the country's manufacturing sector.

Meanwhile, looking at Japan's actual economic growth, after a 3.3% contraction in GDP in the third quarter, GDP shrank by 0.4% in the fourth quarter, unexpectedly falling into a technical recession. According to data from the Japanese Cabinet Office, Japan's nominal GDP in 2023 was 59 trillion yen, approximately 421.06 billion US dollars, lower than Germany's nominal GDP of 44.561 billion US dollars, causing Japan to drop from the world's third-largest economy to the fourth.

Furthermore, Bank of Japan Governor Haruhiko Kuroda reiterated a dovish stance, stating, "We need to confirm whether the wage-inflation positive cycle will start and strengthen." The yen has weakened, with the US dollar falling below 150 yen, reflecting to some extent the challenges facing the Japanese economy.

Japanese Stocks Respond to Company Earnings

Wall Street investment banks generally believe that the rise in Japanese stocks is largely supported by corporate profit prospects, a weaker yen, and the loose monetary policy of the Bank of Japan, rather than being affected by the slowdown in the Japanese economy.

Charu Chanana, a strategist at Saxo Capital Markets, believes that Nvidia's earnings report has become the catalyst for Japanese stocks hitting a historic high. From the resilience of the U.S. economy to the tailwinds of corporate reform, coupled with the weak yen, the Japanese stock market will continue to be an investment story where macro and momentum meet, "still far from this cycle's peak."

Morgan Stanley analysts believe that the biggest driving force behind the current rise in Japanese stocks comes from improved corporate governance, and this factor may continue to benefit the performance of Japanese stocks this year. If Japanese companies achieve higher capital efficiency, their valuation may further increase.

The report points out that thanks to Japanese companies' efforts to improve production efficiency and cost control, the profit margins of Japanese companies have continued to rise to historic highs. Profit expectations for Japanese companies have also significantly improved. At the same time, funds from home and abroad continue to flow in, driving up the valuation of Japanese stocks. From early 2023 to mid-February 2024, foreign funds have net inflows totaling over $55 billion, the fastest pace since 2014.

From a valuation perspective, the valuation of the Japanese stock market remains relatively low, unlike in 1989. According to World Bank data, at the previous peak 34 years ago, the total market capitalization of the Japanese stock market accounted for 37% of the global stock market, exceeding the U.S.'s 29%.

Currently, this ratio is only 6%, with the total market value of the Nikkei Index at 68 billion yen, lower than the sum of Apple and Nvidia. According to Refinitiv data, measured by the most commonly used valuation indicator - the forward price-to-earnings ratio, this indicator exceeded 50 during the bubble period, while the Nikkei Index currently has a forward P/E ratio of 20.5, Nasdaq Index at 25, and S&P 500 Index at 20.4.

After this round of sharp rise, the trading prices of 37% of Japanese listed companies are still below their book value. In contrast, only 3% of stocks in the S&P 500 Index trade below book value. The same proportion for the Stoxx Europe 600 Index is only one-fifth. In theory, this means that if these companies are managed properly in the future, there is potential for an upward trend.

The long-term weakness of the yen also supports the performance of Japanese export companies' stocks. Analysis indicates that benefiting from the weak yen, the resilience of the U.S. economy, inflation, and other factors, both large and small Japanese companies are currently at record high profit levels.