Will Nikkei’s record-breaking rally sustain even as Japan’s economy sputters?

Japan’s Nikkei stock index has been on a record-breaking spree on the back of robust earnings and investor-friendly measures. But the country’s ailing economy has experts divided over this sustainability of this rally.

The Nikkei 225 surged past the 40,000 mark on Monday, with some economists forecasting it still has room to climb, having surpassed the 1989 record high of 38,915.87 last month.

“I would not be surprised if Nikkei hit 50,000 in a matter of a few years. Sector-wise, high-tech related companies will continue to be promising,” Kazuo Momma, Mizuho Research Institute’s executive economist, told CNBC via email.

Japan’s corporate governance reforms have been a key driver for the country’s stock markets, Momma said, while stressing that stock indexes do not necessarily represent the entire economy that includes SMEs and households.

SMEs are a critical lever in the Japanese economy, accounting for 70% of national employment and 50% of the country’s economic growth. 

Weaker yen, as well as investors looking to pare their exposure to China have also fueled the rally in Japan stocks.

“The depressed China’s economy and a shift of investors’ sentiment [away from] China also contributed to increasing foreign investors’ interest in Japanese stocks,” said Sayuri Shirai, professor at Keio University and former Bank of Japan board member.

Why Nikkei rally may not last

Japan Inc’s solid third-quarter earnings prompted Bank of America in February to upgrade their 2024 year-end forecasts for the Nikkei 225 to 41,000 from 38,500. 

While the profit margin of firms in 2023 has improved significantly, partly owing to a series of successful price hikes, this could be just one-off development, said Momma.

He does not expect the Nikkei to continue its uptrend in a straight line going forward, with some corrections possible in the next few weeks or months.

“I would not be surprised if Nikkei goes down 36,000-37,000 levels at one point around mid-year,” he said, adding that even if that happens, the Nikkei would likely regain to 40,000 level by year-end.

Shirai said that foreign profits are heavily influenced by the dollar-yen rate, which lends a note of caution to the sustainability of the Nikkei’s blistering rally.

“It is still too early to say this trend is sustainable. Domestic economy remains weak,” she said. “In Japan, there is no strong enthusiasm … The economy is much weaker due to ageing and low productivity growth,” said Shirai.

Japan has been grappling with having the world’s oldest population, which poses an increasing strain on the country’s public finances.

Shirai added that given how Japan’s higher stock prices are in part driven by a robust U.S. economy, investors have to be cautious as declines are possible.

Also, should the yen strengthen towards 140 against the greenback, this “huge tailwind for earnings” will disappear, Amir Anvarzadeh, Japan equity market strategist at Asymmetric Advisors told CNBC.

“In fact, by Q2 of this year even if yen remains around where it is, much of the forex-related boost will fade,” he said, warning that the stocks multinationals and big exporters that have pushed the Nikkei higher will likely drop.

A recovery in China’s economy from current lows could also tip the balance towards money leaving Japan for China over the next quarter or so, said Anvarzadeh, who also warned of downside risk to the Nikkei.

Additionally, against the backdrop of a slew of weak economic data recently, which has been at odds with the rally in the Nikkei, experts have pointed out that the index does not reflect the state of the country’s economy. 

“The Nikkei is a flawed stock market gauge given its price-weighted methodology,” said Phillip Colmar, Global Strategist and Managing Partner at research firm MRB Partners.

In price-weighted stock indexes, a company’s stock is weighted by its current price, as opposed to capitalization-weighted indexes such as the S&P 500 where stocks are weighted based on their valuations.

“Equity markets are sentiment gauges and much more volatile than the underlying economy,” Colmar said, adding that Nikkei’s recent rise is not indicative of a dramatic improvement in Japan’s economic outlook, but of a reduced risk of chronic deflation.