Global investors just can’t seem to get enough of Japan, with the opposite proving to be the case for China.

MSCI Japan is starting 2024 as the world’s best-performing major equity market – up another 7 per cent and setting post-bubble highs after a stunning 27 per cent rally in 2023. In contrast, MSCI China has been the world’s worst performer – minus 8.8 per cent year to date – extending a near 60 per cent drawdown since its February 2021 peak.

The positioning reflects the stark divergence in investor sentiment. The first three weeks of 2024 alone saw foreign investors plough a whopping 1.7 trillion yen (S$15.4 billion) into Japanese equities. By contrast, a recent Bank of America survey found global funds are now the most underweight on China that they have been in a long while.

With this shift, Tokyo has now overtaken Shanghai to regain its crown as Asia’s biggest stock exchange by market capitalisation, reflecting an increasing preference for Japan as an investment alternative to China in Asia. But after such a sharp rally in one market and sell-off in the other, how should investors be positioned? 

A reversal of fortunes

Asia’s two largest economies are seeing a reversal of fortunes from decades past – a period that conditioned investors to believe Japan would never deliver on reforms to sustainably tackle deflation, while Beijing would always deliver game-changing policy support. 

Even as the introduction of Abenomics in 2013 failed to sustain investor enthusiasm, Beijing‘s repeated policy shock and awe helped stabilise the world economy during the 2008 global financial crisis and pull the Chinese market out of its slump in 2015. Those decisions did, however, plant the seeds for the structural shifts we see today.

In Japan, the slow burn of corporate reforms is finally accelerating, deflation appears over, and nominal growth has broken out of its 30-year hibernation. The Bank of Japan (BOJ) also appears committed to a gentle normalisation process from negative interest rates, supporting a favourable investment climate. 

But while investors believe Japan is exiting its lost decades, they fear China is entering its own. Saddled with a mountain of debt, economic imbalances and its longest deflationary streak since the Asian financial crisis of the late 1990s, Beijing is looking to complete a painful policy-induced transition to new growth drivers while resisting a return to the playbook of old.

Meanwhile, with national security concerns now trumping efficient markets, Japan has emerged as a haven for supply chain diversification and regional investment – largely at China’s expense. But Japan itself is not fully immune from geopolitical risks: Further United States blockades could also hurt Japanese tech exports bound for China.

The bull case for Japan

Global investors are running with Japan’s structural bull case, but fundamentals, too, offer cause for optimism. Wage growth and inflation should support nominal gross domestic product (GDP) growth of around 2 per cent in 2024 – compared with the 20-year average of just 0.3 per cent – with financial year 2024 earnings likely to hit a record for a third straight year.

Meanwhile, the yen remains a tailwind at current levels, even if it gradually strengthens as the BOJ normalises and the US Federal Reserve’s easing cycle begins.

Corporate governance reforms should further lift margins and shareholder returns – and there remains plenty of room for improvement. Half of Japanese companies are trading below book value, compared with just 4 per cent of companies in the US, reflecting subpar profit margins of around 6 per cent, well below the US’ at 12 per cent and Europe’s at 9 per cent. Shareholder returns lag as well with return on equity, or ROE, of 8.5 per cent versus 18 per cent for the US and 12 per cent for Europe.

Meanwhile, Japanese households currently allocate just 11 per cent of their assets to equity investments, compared with 40 per cent in the US. As inflation returns, and the new Nisa tax incentives kick in, retail allocations to Japanese equities could gradually rise over time. Nisa, short for Nippon Individual Savings Account, is a new type of tax exemption programme in Japan for small investments. Japan’s valuations at 14.8 times forward earnings also still look undemanding compared with the US at 19.8 times and global equities at 16.5 times.

Still, market risks remain ahead of an anticipated monetary policy regime shift, calling for a selective approach to finding opportunities. In particular, large-cap Japanese banks should benefit from the end of negative interest rates early in the second quarter of 2024, higher Japanese government bond yields, still-cheap valuations and solid dividend yields. Laggard growth stocks in the domestic Internet sector also look set for above-average earnings growth as US yields decline.

China: Pessimism prevails

The recent step-up in support, including the 50 basis-point cut to the reserve requirement ratio and fresh property easing, suggests Beijing is growing increasingly worried about the dire state of the economy. With housing in its fourth year of a downturn and comprising one-fifth of GDP and two-thirds of household wealth, we think a decisive stabilisation remains crucial to restoring domestic confidence.

As a busy first-quarter political calendar approaches, a bigger policy programme could materialise should the National People’s Congress set a growth target closer to 5 per cent for 2024. In an upside case, for instance, this could include sustained buying by the national team to boost markets, large-scale monetary easing to fund multi-year urban redevelopment, or even direct government purchases of property-related securities.

Still, as investors await more “forceful” policy actions, the more defensive and high-yielding sectors, such as large-cap banks trading at a 9 per cent to 10 per cent dividend yield, are likely to outperform.

In the meantime, depressed sentiment is drowning out the steady advances that China is making towards tech self-sufficiency and industrial upgrades. Historically low valuations (about eight times forward earnings) mean that China now presents a cheap optionality for patient money. Long-term transition winners include companies with a rising global presence, and those that can tap China’s changing consumer trends as well as its deepening tech ecosystem.

Regime shifts can entail complex risks. For China, an uncertain economic transition lies ahead. And for Japan, the BOJ is poised to exit from over a decade of negative interest rates. Different challenges lie ahead for both markets, but each offers a unique opportunity set for investors to tap.

• The writer is the Asia-Pacific head of UBS Global Wealth Management’s Chief Investment Office.