Introduction

The central character of “Babylon Revisited” by F. Scott Fitzgerald is called Charlie Wales. Charlie was a casualty of the 1929 Wall Street crash. Classic themes of alienation and loneliness are prevalent, as in many of his other novels. “I heard you lost a lot in the crash” says his friend. “I did” said Charlie, “but I lost everything I wanted in the boom”.

My colleagues have often thought that I prefer bear markets. My wife has seen a new spring in my step recently and even my co-manager, David has noticed a new-found burst of energy. I can’t help it. Thirty-five years in Japan has left me by nature a more cautious individual. That has its challenges, and I freely admit that quantitative easing at the peak was problematic for myself and many value focused managers. However, downside inflexion points have been my strength, and my gut tells me that there is a rising chance of significantly more volatility in markets and a growing chance that de-globalisation, fiscal retrenchment and tariffs could be destabilising at a time when inflation is now secularly more entrenched. This change in structural dynamics after 40 years of disinflation (first from policy and then from integration) has yet to be fully appreciated. It seems likely that the policy choices and settings will be different in the next few years – the easy option of injecting liquidity and expanding government debt to soften downturns may no longer be costless.

In the USA the output gap is at its tightest since 1987. Wage inflation persists, hiring continues and labour shortages whilst having peaked out are still there. Tariffs will only add to the inflation worries. The impact of radical change from Trump 2.0 and DOGE is uncertain. Tariffs and fiscal retrenchment are counterbalanced by a healthy consumer, bank lending, deregulation and rampant animal spirits. US data will be almost impossible to predict. Currently US earnings are heavily reliant on technology and AI. In the last four years 63% of earnings came from these sectors. 48% of next year’s earnings growth is predicated to come from these areas. Deepseek challenges “first-mover market leaders”. Like a broken record, and I will say it again, the US market looks very expensive. My friend Ron Napier in Texas told me last week that since 1930-2024 the stock market is ranked 97th percentile in terms of valuations. Similar valuation nosebleeds have very often been followed by sell-offs, although timing is everything. “US exceptionalism” is now well embedded in global portfolios. China must reset its model from capex intensive to domestic demand led. The focus of investment has shifted from housing to industrial capacity, but it seems very hard to export this production volume without global push back. Tariffs from Trump reflect this challenge and will not help that model. The challenges they face are not dissimilar to those that Japan confronted and struggled with. The lesson is that periodically short-lived bear market rallies will offer upside but are not to be trusted.

Corporate Earnings

Current earnings out in Japan are optically positive for manufacturing but are flattered by yen weakness. The non-manufacturing sector without this tailwind is performing a lot better. The chart below looks at Socionext (6526) (chips), Honda Motor (7267) and Nidec (6594). All three have struggled despite a weaker Yen as changing product mix, strong competition and lingering economic weakness have hurt their business.

A more domestic feel (below) is seen so far this year in the market. Little has separated large companies from small. Banks and Real Estate stand out as opposed to Automobiles and Trading Companies. Technology has held up better than we thought but propped up by domestic facing software names such as NEC (6701) and the long expected Fujitsu General (6755) takeover.

Last year it was all about Japanese large caps acting on Corporate Governance at the expense of small caps (below). The forensic microscope of the Tokyo Stock Exchange (TSE) will begin to put even more pressure on “non-conformers” either to step up their efforts or to de-list. This scribe believes that we will see on a net basis substantially less listed companies in Japan in a few years’ time. Given a highly volatile global backdrop it is difficult to imagine, and we do not assume, much valuation expansion. It’s all up to EPS growth. The challenge may lie in the new found strength of the yen. A 10% move upwards against the dollar reduces market EPS 3.5% which will act as a headwind for many stocks.

The Corporate Governance Revolution 

At Zennor we have a view. When we set up Zennor, we did so with the changes in corporate governance as our catalyst and our edge was that we had visited so many small and mid-caps in our careers. The TSE have beautifully summarised the transformation of corporate governance.

The result is we expect more takeovers, more activism, smaller cap out-performance, as the lowest hanging fruit in large caps is closing somewhat. “Protecting Minority shareholders” is crucial. No MBO’s at rip off prices and as crucial is the proposed further scrutiny of parent/child listings. Zennor have played this theme since inception. Zennor Japan Fund has 13% of its portfolio in these subsidiary listed names. Zennor Japan Income Fund has 20%. The below chart from Morgan Stanley summarises the activism boom we are seeing in Japan. Close to 10% of TSE Prime Market has activists at the gate.

Yen & Bank of Japan Policy

Let us touch on the Yen and Bank of Japan policy. At the time of writing, the yen has had its fourth week of rising against the dollar. This week we saw much improved labour cash earnings coming in at +4.8% YoY. Household spending also surprised economists, coming in at +2.7% YoY. David returned after Christmas saying Tokyo was booming, although admitting that the economy is lopsided. To put that wage growth into context. That is the strongest growth in thirty years. One BOJ board member, Mr Tamura believes that rates could double in 12 months. Former Governor, Mr Kuroda pronounced “the end of deflation”. The below chart shows Japanese consumer prices since 2012. These, coupled with a better outlook for real wage growth mean the BOJ will hike further - and are getting more hawkish as their confidence grows.

Purchasing power parity suggests a fair value below ¥110/$1. If you split David’s and my view you could see ¥135/$1 this year. Yet again we will stick our necks out. Expect the yen to strengthen more dramatically against sterling. Do not rule out a sterling crisis. Currency crises are started by lack of confidence. Last August we had a taster of what can happen when “one-way bets” go wrong. The yen moved from ¥160/$1 to ¥140/$1 before positions could adjust. Whilst we do not know the full extent of the yen carry trade, what we do know is that Japanese pension funds and life insurers have consistently sold Yen to invest in foreign assets. Many insurance firms and banks have indicated that they will reduce or reverse their exposure if domestic rates offer a sufficiently high return. All countries revert to their own currency in a crisis.

As one strategist puts it: “Borrowing in Yen at deeply negative real rates has fuelled the latest inflation in US tech valuations… the biggest risk to the bull market is not a US recession. The biggest risk is the end of the deeply negative real rates in Japan versus the US”.

Expect to see less euphoria surrounding the largest stocks in Japan. City Banks have re-rated well past 1x book value as they embraced balance sheet reform. We believe that externally related names will probably under-perform. How high and when tariffs will happen is an unknown, but Japan is unlikely to escape unscathed. Auto’s (Toyota (7203) have had a forex tailwind but demand in most areas is soft and structural challenges loom large. Don’t get me started on Tokyo Electron (8035) powered by AI thematic investment! Can these market leaders carry on performing or does the advent of Deepseek offer an alternative, somewhat darker future – at least for valuations?

Opportunities in Japan

The opportunities lie with out of favour mid-caps and small caps in the domestic space. Not only have they been seen as “lagging” in the adoption of corporate governance, but activists are moving on from successes such as Olympus (7733), Dai Nippon Printing (7912) and Seven & i (3382). Recently we have seen fireworks at our holding, Fuji Media Holdings (4676), where the Chairman has resigned but the power behind the throne is yet to throw in the towel. The vultures are circling everywhere where signs of weakness exist and where President approval ratings are plummeting. We have recently taken up our weighting in Kyoto Financial Group (5844), where a well-known activist owns 7% of outstanding shares. The market cap is dwarfed by anachronistic cross-shareholdings and the core banking business is worth something, especially in a rising interest rate environment. Even Kyocera (6971), has found its way into our stable. They will be buying back 10% of the company this year and a further 10% over the following two years. The core business is OK in some areas, but radical surgery is needed at AVX and loss-making flip chip packaging. They have committed to exiting ¥200bn of sales in non-core businesses and will more aggressively sell down their investment shareholdings. Their holding in telecom provider KDDI (9433) alone is worth 67% of their market cap. Whilst Kyocera has long been cheap it is the new found commitment to harder choices and change that is the catalyst for our investment at an enterprise value of ¥500bn or less than 2x EBITDA.

As mentioned earlier, the parent/child theme will grow new wings this year as the TSE refocuses on this area of distorted governance. We feel that the hidden gains on real estate have much further to run. Private equity groups buying into areas such as logistics have seen much more “intrinsic value” than traditional fund managers.

I love this chart from Morgan Stanley. It shows how stocks with growing PBR and ROE have handsomely performed. Neatly, with the Zennor team you have two specialists. One in value and one in growth.

Meanwhile, the cumulative share buybacks taking place are enormous. This year close to $180bn. Not all activisms will work particularly if the target is seen as strategically important to the government or where the shareholder mix is still aligned to insiders. Think Toshiba (6502). The key for us is exploiting inefficiencies in Japan that have balance sheets and capital structure out of sync with the new corporate governance regime. Too much net cash, too many investment securities, too many hidden gains on leased assets resulting in too low ROE versus WACC. Japan is the wild west if you know where to go. The problem is that many do not and only focus on 100 names at most.

In Summary

The US economy still feels dynamic. However, volatility in the data will be the story of 2025 as we contend with fiscal retrenchment and tariffs versus tax cuts and deregulation. The valuation on US equities is another matter. This scribe has been wrong too long. But I do think that there is a good chance we get our -20% peak to trough this year. Already in five weeks we have had to grapple with Deepseek/AI and then Tariffs. Could the Yen still play a role in all this? Trump’s obsession with tariffs began in the 1980’s when Japan’s trade practices (legitimately) were very much in the US cross-hairs. Don’t bet against Trump and his team talking up the yen to rebalance the trade books.

The Yen could make us a lot of money. Sterling looks very vulnerable. Above all stock picking is back. Bear markets build good fund management business, and I am reminded of 2001. The chances of making positive sterling and dollar returns are extremely high with the right stock-picker, no matter what direction the global macro takes. Volatility will be high. That will create opportunities. Pragmatism and flexibility will be crucial. A balanced approach that fuses value and growth opportunistically should serve us well.