Mid-year outlook 2023: Does the Nikkei 225 rally have more legs to run?

Nikkei 225 has been the clear outrunner year-to-date

Year-to-date, the Nikkei 225’s performance has way towered above its peers, surging more than 30% to cross the 33,000 level for the first time since 1990. With the index failing to deliver a new record high for more than 30 years ever since its asset price bubble's collapse in the 1990s, expectations are mounting that an era shift is in the making.

A series of catalysts are on the radar, which include a corporate governance overhaul, hopes that Japan will break free from its deflationary cycle to being a beneficiary of supply-chain diversification with souring US-China relationship.

Not to mention the endorsement from Warren Buffett, who has just recently increased its stake in five major Japanese trading firms (8.5% versus 7.4% in April) as a show of conviction for their longer-term outlook.

Shift in corporate governance may be a multi-year tailwind

Fundamental weaknesses in corporate governance have traditionally served as a deterrence towards Japanese stocks over the past decade, as past experiences from the "post-bubble blues" have instilled a long-lasting culture of heavy capital accumulation while deprioritising shareholders’ returns.

That could seem to head for a change, as markets are finally seeing more forceful action from the Tokyo Stock Exchange in improving capital efficiency. Listed companies with a price-to-book ratio below one are in the crosshair, having to be held accountable for their cost and efficiency of capital. Threats of potential delisting may add to the clear resolve from authorities for a change.

No doubt it may be too premature to deem that the reforms will be a success and attempts for a change have failed many times before, but it will be looked upon as a step in the right direction. More follow-up efforts among companies in terms of share buyback announcements and more shareholder-friendly stances will be on the lookout as indications of progress, which may support further re-rating from current undervalued state and lift the longer-term appeal of Japanese stocks.

Foreign investment for Japan’s equities has turned in an 11th-week net-buying streak

Foreign investors have been convinced thus far, as Japanese equities witnessed its 11th straight week of net-buying – a phenomenon which has not occurred since March 2013. Considering that investors (eg. fund managers) tend to build up their exposure over a period of time, further shift in allocations to Japanese equities may continue to provide some support for the index, with any dips potentially deemed as a buying opportunity.

A ramp-up in foreign investment (or foreign share ownership) in these companies may also translate to mounting pressure to place more focus on profitability and efficient capital allocation, which seems to feed into the drive for improving corporate governance as well.

Risks: Hopes of sustainable inflation still a black box, policy pivot on the radar

A continued pull-ahead in Japan’s “core core” inflation to its highest level in more than 30 years has also given hopes that Japan may be able to break free from its deflationary cycle. But considering that improving wage dynamics has not been broad-based, much may still be up in the air for now.

Nevertheless, a policy pivot from the Bank of Japan (BoJ) seems to be a question of when and not if. We have seen a surprise tweak to its yield curve control (YCC) policy last December, which prompted a 3% intra-day plunge in the Nikkei. Therefore, any further moves could trigger a bout of volatility in the index, with any higher bond yields reducing the traction in holding equities. At least for now, expectations are that conditions could remain accommodative over the next two meetings, which allow market participants to put the consequences of any policy pivot in the backseat for the time being.

Technical analysis – Bullish flag formation as continuation pattern on monthly chart, near-term moves guided by 20-day MA

The Nikkei 225 has been retaining its strength lately, as the Relative Strength Index (RSI) has managed to revert from overbought to more neutral territory without much of a dip this week. A bearish crossover was formed on its moving average convergence/divergence (MACD), but previous attempts for a bearish cross (1 June 2023, 9 June 2023) has proven to be a bear trap, which provides less conviction that it should be looked upon as a solid guide.

Perhaps one to watch in the near term will be its 20-day moving average (MA), which has been supporting the index steadily over the past two months. As long as the fundamental outlook stays intact, any retracement on profit-taking activities may still be met with dip-buying, with a series of support lines (20-day MA, 50-day MA, Ichimoku cloud) aiding to drive the formation of any higher low as a continuation of its prevailing upward trend.

On the monthly chart, a bullish flag formation has been presented, which serves as a continuation pattern for its upward trend. The trading target as derived from the projection of a proportionate distance from the breakout level points to the potential for the index to deliver a new record high, but nevertheless, shorter-term focus will be on its December 1989 top at the 38,900 level.