Japan’s resurgent Nikkei 225 is stoking bubble fears. This analyst isn’t worried

March 4, 2021, 8:03 AM UTC

Japan’s benchmark Nikkei 225 index surged past the 30,000-point threshold last month, marking a three-decades comeback from the last time it reached that level in 1990, just as the country’s overheated economy started to collapse.

Today’s Nikkei has followed the global market rally, driven by fiscal stimulus and a huge influx of capital into the market from Japan’s central bank. But soaring stocks alongside an economy still recovering from the COVID-19 pandemic is stoking fears that Japan is facing another bubble about to burst. Arcus Investment cofounder and strategist Peter Tasker, a veteran Japan market analyst based in Tokyo, doesn’t buy into the worries. He remains optimistic that at this point, history won’t repeat itself.

“I think for Japan and many of the markets in the world, [particularly in Asia], they are actually not expensive on the basis that we’ve reopened the economies and got back to roughly the same level of corporate profitability that we had before,” Tasker said. Japan’s gross domestic product shrank 4.8% in 2020, compared to 2019, outperforming the 5.3% drop projected by the International Monetary Fund. What’s more, Tasker says, Japan investors are more sophisticated than they used to be, and Japanese corporations have healthier balance sheets.

In an Eastworld Spotlight conversation with Fortune’s Clay Chandler this week, Tasker talked about the Nikkei’s performance, changes to Japanese investment culture, and where the index might go from here. This interview has been edited for length and clarity.

Fortune: How the Nikkei 225 composed and calculated? 

Tasker: It’s a bit like the Dow Jones index in the U.S. It’s an average of absolute stock prices, without reference to the number of stocks in the issue. And that does lead to some significant anomalies. Companies with a very high stock price will have a very high weighting in the Nikkei index, even if they are not the largest companies by market value because they don’t have that many stocks.

The two biggest stocks in the Nikkei 225 are SoftBank and Fast Retailing, which make up 20% of the index. If they do well, that’s going to push up the Nikkei index. So it is fair to say that Nikkei has moved a long way ahead of the rest of the market, because of the composition and the great success of those two companies in particular, which have really blown the doors off.

Tell us a bit about the change in the composition of investors in Japanese equities that are driving the movements of these stocks.

Tasker: What we’ve seen more recently over the past couple of decades is the gradual development of an investment culture amongst individual investors. [Along with professional investors], there is now what you might call someone not hugely wealthy, but people with quite a bit of capital to invest in the markets. Some of these are sort of like day traders, and some of them are more sophisticated. 

Particularly we’ve now got the Government Pension Investment Fund (GPIF), which has 50% of its asset allocation to equities, and half of that in overseas equities. Traditionally the GPIF basically just bought Japanese government bonds, and there was no real attempt to maximize returns or to look professionally at asset allocation. So [the fact that it now also purchases equities] is a huge, huge new factor in the markets, and in the kind of investment culture in Japan.

More recently, [Japanese] companies are buying back their own shares in quite a large amount. This is actually a pretty good thing for Japan because many of the companies have been overcapitalized. They’ve got too much cash at hand. And that actually reduces over time the returns that they can make, the returns on equity and returns on capital, because the returns on cash are zero or worse in the world we’re in now. So actually returning that cash to shareholders who are highly likely to reinvest it in other stocks is a good thing. These are all aggressive trends that have been a long time coming but have started to accelerate really over the last five or six years.

You’ve written about the “grand narrative” underpinning this rally. I wonder if you could maybe say a little bit about that.

Tasker: I think the rally so far has been a domestic rally. But there are foreigners, since the end of last year, who started to look at Japan. And there’s definitely a sort of coronavirus element about how countries have done; these are very soft-power kind of tangential—not direct investment—type ideas. I think what we are really seeing and recognized now is the culmination of a process of Japanese companies becoming more commercial, more profitable, more concerned about shareholders and balance sheet management margins. Everything has improved tremendously over time. 

So part of this is Japanese companies getting their act together. But how much credit do you give to so-called Abenomics, former Prime Minister Shinzo Abe’s drive to pull Japan out of its decades-long slump?

Tasker: I think that was a kind of catalyst. The previous government had not tackled the big problems of deflation and stagnation. And as a result of that, when Abe walked into the Prime Minister’s office at the end of 2012, Japanese nominal GDP was the same as it was in 1992. There had been no growth in nominal GDP for 20 years. That means essentially no growth in company revenues, no growth in salaries. That’s not a good place to be in. So [Abe] jump-started the process. Things like the reform of GPIF and the corporate governance code, which were kind of babies of that Abenomics era, have turned out to be a very important factor in the [Japanese] stock market.

One of the main pillars of Abenomics was to implement ultra-loose monetary policy by keeping interest rates very low, and the Bank of Japan (BOJ) has also become a very significant investor in the market itself. Can you enlighten us a little bit as to how that works?

Tasker: This is obviously a very controversial area. By putting the central bank in [the market] as a small buyer, [the BOJ] hoped to give a little bit of encouragement and to show that the government wanted the market to go up. Currently, the BOJ is the biggest investor in the market. In fact, it’s bigger than the GPIF because the GPIF generally reduces holdings when the market goes up. But the BOJ hasn’t sold the holdings it bought all through the last 10 years, and it has gone up and up and up.

The BOJ got huge profits on their stock holdings, and this is a sort of a dilemma now. They have reduced the risk premium on the market, and people think it’s safe to come and buy the market now because it’s obviously very buoyant. But what are we going to do with all the stocks we’ve got? They’re going to have to come up with some neat formula for exiting equities without disturbing the market, because it’s such a large amount. Now if the BOJ said they are going to sell all their holdings tomorrow, the market would tank because it simply can’t take about 8% of the market cap. You can’t basically dispose of a cap like that.

Hong Kong did a very smart exit strategy [by disposing of stocks purchased by the government in 1998]. They created a fund and incentives, basically a kind of auction for individuals or wealthy people to buy. The stocks had a bit of a discount, and [buyers] got a special reward if they held them for a long time. That kind of approach I think is the sensible way for Japan to go from here because we don’t really want the central bank to continue to be the biggest owner of stocks.

Do you think this rally has further to run? Or is it already looking like we’re getting back into a bubble territory?

Tasker: I think for Japan and many of the markets in the world, [particularly in Asia], they are actually not expensive on the basis that we’ve reopened the economies and got back to roughly the same level of corporate profitability that we had before.

There may be a change in the kind of stocks that people favor. Clearly from the last year or so, the whole stay-at-home thing has led to a tremendous polarization between the companies that are doing very well with the virus, and those that have been hurt badly. So I think there’s going to be a closing of that gap for sure, as we move back to some kind of normality. We don’t know how many of these changes we’ve experienced are going to be permanent. That’s going to be something to know, and we’ll have to see how people react. As you reopen, people will want to enjoy themselves and socialize, go to places and experience all those experiences that they had before. It will be more normal than people think.

So you think that reopening is a plus for stock prices? That it’s a kind of a demand shock as everybody returns to consumption?

Tasker: I think the likelihood is that we’re going to see some very high numbers for GDP growth across the world coming through this year. The bad numbers last year were just off the charts. I think we’re going to be off the charts on the upside this time. And that’s generally going to be a positive background for corporate earnings. 

What I would ask, though, is that what are the central banks going to do? That’s a crucial point. Because, as we know, there was a sort of massive tsunami of money that has hit markets, and it has also hit households. This is different from what we saw in the global financial crisis. Now you have people with high levels of savings, which weren’t planned savings but compulsory savings because you can’t spend the money in the way you wanted. So this suggests that there could be a pullback by central banks at some point; the money tap goes off. And that could be a bit of a reality check for investors and may put upward pressure on interest rates, as we’ve seen to some extent already, in these last couple of weeks.

So are you looking for the Nikkei to at some point break its all-time high record of 38,957.44? Or do you think that is something that’s a long, distant prospect?

Well, it’s about 30% from here. So who knows, never say never. But it will take us several years of decent gains. We’ll see it accomplished this decade for sure.

This interview is part of Eastworld Spotlight, a series of conversations on matters of business, tech, and finance with executives, experts, entrepreneurs, and investors in Asia. Subscribe to Fortune’s Eastworld newsletter to get them in your inbox.