Japan’s stock market setup looks similar to late 2023. Here’s what it means

Japan's equities market may be entering a scenario similar to the late-2023 Fed pivot rally, according to a Bank of America report. This assessment stems from a significant rise in U.S. long-term Treasury yields. The U.S. Treasury has decided to increase the cap on its purchases of longer-dated government bonds, raising it to at least $4 billion per operation for securities maturing in 10-20 years and 20-30 years, from $2 billion between September 9 and November 4.

This move resembles the conditions observed in November and December 2023, when U.S. long-term yields fell sharply due to economic data weakening, inflation slowing, and markets anticipating an end to Federal Reserve rate hikes. Consequently, Japanese equities have risen towards year-end, despite the yen appreciating against other currencies.

However, Bank of America notes that the current backdrop differs from 2023, as the yen remains weak despite foreign-exchange interventions, Middle East tensions have emerged, and a manufacturing recovery could potentially drive higher Japanese corporate earnings and interest rates. Moreover, the Bank of Japan's potential acceleration of rate hikes suggests it may be premature to assume the rate hike trend has concluded.

While Bank of America believes the Treasury's larger buybacks could prevent long-term yields from increasing uncontrollably, sustained elevated yields could leave Japanese equities in a situation where they benefit from profit growth alongside rising interest rates, rather than the falling-rate environment that fueled the late-2023 rally.

The bank anticipates a gradual shift from momentum- and beta-driven performance to more selective stock picking. It advises investors to be selective among artificial intelligence-related shares based on earnings and valuations, emphasizing IT services, gaming, and intellectual property companies that trailed the AI rally but have reported strong first-quarter results.

Additionally, domestic-demand stocks could benefit if the yen stabilizes, while small- and mid-cap growth stocks may recover if the currency stops weakening. Bank of America expects value stocks to retain an advantage as long as interest rates continue to rise, as most of these themes mirror the November-December 2023 market. However, the bank concludes that the overall environment is likely to favor stock pickers rather than a broad, momentum-led rally.