Japan's Nikkei goes past 40,000 for the first time. What's fueling the rally?

The positive sentiment in Japanese market is driven by the hope for US interest rate cuts, signs of cooling inflation, and a surge in interest surrounding artificial intelligence within the big tech sector.

Japan’s Nikkei hit another high to breach the 40,000 level for the first time on March 4, with technology stocks giving the blue-chip index the biggest boost.

The Japanese market's record run is being powered by sustained gains in chipmaking and chip-adjacent stocks on expectations that artificial intelligence (AI) will drive a demand boom in the coming months.

The rally has made Japanese stocks some of the hottest buys of the past year.

What's fuelling the rally in Japan stocks?

Markets catching up

The Japanese equity market reached a new high after almost 35 years. "During this period, Japan's GDP in dollar terms increased from 3.1 to 4.2 trillion dollars. This indicates that the equity market is aligning with the broader economic growth, showcasing a catch-up rather than leading the way," said Sujan Hajra, Chief Economist & Executive Director, Anand Rathi Shares and Stock Brokers.

Also Read | MC Explains | Why Japan, Eurozone markets are rising even as recession threat looms

Earnings and wages

Investors are optimistic as corporate earnings in the last quarter of 2023 were 45 percent higher on-year, according to Goldman Sachs analysts. Economists are also cautiously optimistic that Japan might be able to reverse long-running deflation and become more of a normal economy again.

Rising wages amid a tighter labour market by companies like Toyota, Nintendo, and Uniqlo owner Fast Retailing has also boosted confidence in the economy.

Increased FII inflows

Foreign cash continues to pour into Japanese stocks as investors take advantage of the cheap yen and corporate governance reforms that have boosted shareholder returns.

Increased liquidity

According to economists, Japanese stocks have seen increased inflows, thanks to the outflows out of China. As the dragon's economy is unravelling at a pace previously thought unimaginable, and its property market rout has turned into an implosion, foreign investors have started pulling money out and putting it into other destinations including India and Japan.

This has increased the liquidity in Japanese markets which can be attributed for the rise in benchmark indices.

US rate cut hopes

The positive sentiment is also driven by the hope for US interest rate cuts, signs of cooling inflation, and a surge in interest surrounding artificial intelligence within the big tech sector.

Also Read | Japan’s Nikkei 225 breaches key 40,000 level for first time

Positive environment for stocks?

As Japan’s overall economy struggles with anaemic growth amid structural challenges that include a shrinking population and rigid labour force, the key economic readings released recently painted a positive picture for Japanese markets.

Japanese capital spending rose a substantially bigger-than-expected 16.4 percent in the fourth quarter, defying an unexpected slowdown in economic growth as business spending remained resilient.

The Japanese economy officially entered recession, relinquishing its place as the world’s third-largest economy to Germany. While the central bank is still expected to raise interest rates from ultra-low levels by as soon as April, it is still likely to keep monetary conditions largely loose, presenting a positive environment for Japanese stocks.

Will the rally sustain?

While Japan's markets are touching new highs, economists are of the view that if the economic indicators remain weak for a longer period with recession becoming a problem, the markets may soon see a sharp fall. The Bank of Japan is reportedly on track to end negative interest rates in the coming months.

Around 76 percent of the economists polled by Reuters expect the BOJ to scrap yield curve control, with almost all saying ultra-loose monetary conditions will end. This will reduce liquidity and Japanese markets may likely see huge outflows.

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