[SCMP Column] China’s Economic Loss Is Not Necessarily Japan’s Gain

Japan Gains Spotlight as Asian Investment Destination Excluding China
Prolonged Chinese Slowdown Inevitably Impacts Japanese Stock Market

Nicholas Spiro, Loresa Advisory Partner [Photo by SCMP]

The year 2024 is expected to mark a milestone for Asian stock markets. On January 23, the market capitalization of the Indian stock market surpassed Hong Kong’s for the first time in dollar terms. The third-largest economy in Asia became the fourth-largest stock market in the world.

In early January, the Hong Kong Hang Seng Index fell to the level it was at on July 1, 1997, when Hong Kong was handed over. The Hang Seng Index has dropped about 50% since its peak in January 2018. In contrast, India’s Mumbai Stock Exchange (BSE) Sensex index surged 200% compared to February 2016.

Most notably, on January 11, the Tokyo Stock Exchange’s market capitalization surpassed that of the Shanghai Stock Exchange, allowing Tokyo to reclaim its position as Asia’s largest stock market.

The stark divergence between Asia’s two major stock markets is redrawing the investment landscape in Asia. According to Bloomberg data, from early 2021 to mid-January, $6.3 trillion (approximately 8,403 trillion KRW) in market capitalization disappeared from the Chinese and Hong Kong stock markets. This amount is equivalent to the current market capitalization of the Shanghai Stock Exchange.

Sentiment toward China is so bleak that investors are unsure what needs to happen domestically or internationally for a meaningful and sustained rally to unfold. More aggressive stimulus packages to boost the stock market have faced skepticism due to China’s deep-rooted structural economic problems and the increasing appeal of other Asian markets.

According to a Bank of America (BoA) Asia fund manager survey released on January 16, only 4% of respondents expect China’s economy to perform well this year. Meanwhile, 20% said they plan to reduce their exposure to Chinese stocks, marking the largest scale of reduction in Asia.

On the other hand, the Japanese stock market is showing increasing strength. The Nikkei 225 index has risen nearly 40% since early 2023. It is only 7% below the level it reached in December 1989, just before Japan’s bubble economy collapsed and entered decades of stagnation.

Global funds are flocking to Japanese stocks, driven by hopeful signs that deflation will ease. Additionally, the continuation of ultra-loose monetary policy, a weak yen, and corporate governance reforms have boosted investor sentiment. In the BoA survey, 59% of respondents said they are increasing their allocation to Japanese stocks.

One reason Japan is a major theme in Asian stock markets and popular among international investors is the geopolitical reshaping of supply chains and the growing demand for Asian investment products excluding China.

BoA stated that Japanese stocks benefit from 'ABC,' meaning 'Anywhere But China,' global liquidity. Meanwhile, Morgan Stanley says Japan holds a strong position due to the 'dynamics of a multipolar world,' its role as a 'key U.S. security ally with substantial technological leadership,' and its 'ability to benefit from supply chain onshoring.' In other words, China’s losses are Japan’s gains.

But is this analysis entirely accurate? The main reason Japan’s stock market is attracting so much attention is that foreign investors’ holdings have been small for a long time and the market has been undervalued. BoA points out that Japan’s weight in the Morgan Stanley Capital International (MSCI) All Country World Index (ACWI) is only 5.5%, compared to about 45% just before the bubble burst in the 1980s.

Moreover, although Japanese stocks are approaching the bubble era peak, they remain significantly cheaper compared to 1989. This enhances the appeal of a turnaround story driven by reflation and governance reforms.

The 'Asia excluding China' investment strategy should be approached with caution. Japan has emerged as an attractive market deep and liquid enough for global investors to maintain exposure to Asia while reducing risk toward China. However, it does not fully shield investors from China-related risks.

In conclusion, if China’s economic downturn prolongs and deepens, it will inevitably harm the Japanese stock market as well, especially if it coincides with a U.S. recession. Although other Asian countries have stronger trade ties with China, China remains Japan’s largest trading partner and a critical source of revenue in several key industries.

According to Morgan Stanley data, China accounts for 20-24% of sales in Japan’s factory automation, electronic components, and household and consumer goods industries. It also represents 18% of revenue for strategically important semiconductor companies. Semiconductors were identified in the BoA survey as the sector with the largest overweight positions among respondents. Additionally, a separate survey released in early January by the China-Japan Chamber of Commerce found that more than half of the Japanese companies surveyed consider China their most important market or one of their top three markets.

There is no doubt that geopolitical tensions currently favor Japanese stocks. However, the claim of 'Asia excluding China' has limitations in areas dependent on China’s growth. With Japan’s early inflation vulnerable to economic headwinds, especially if the Bank of Japan’s (BOJ) ultra-loose monetary policy ends prematurely, a sharp slowdown in China would be a bad omen for Asia’s largest stock exchanges.

Nicholas Spiro, Partner at Loresa Advisory

This article is a translation by Asia Economy of the South China Morning Post (SCMP) column titled 'China’s economic loss is not necessarily Japan’s gain.'