Why the Japanese Stock Market Just Overtook Germany’s to Become the World’s Third Largest

Watching Japan’s financial markets surpass Germany’s at a time when almost every other aspect of Japan’s economic narrative appears convoluted is almost poetic. The GDP figures are depressing. The demographics are concerning.

For the better part of three years, the yen has been in retreat. Nevertheless, the Tokyo Stock Exchange has surpassed Frankfurt to become the third-largest stock market in the world by capitalization, a change that has taken even seasoned observers by surprise.

The size of Japan’s economy and the state of its financial markets are two topics that frequently get mixed up in discussions about the country. Although they are related, they are not the same. In 2023, Japan’s nominal GDP fell short of Germany’s, a reversal that made headlines throughout Asia and was seen as a symbolic wound by many Japanese.

Official data from February of that year confirmed what analysts had predicted: Japan’s economy was at $4.21 trillion, while Germany’s, driven by a rising euro and inflation driven by commodities, had surpassed $4.46 trillion. It hurt to be ranked fourth for a nation that had the second-largest economy in the world for more than 40 years.

However, expectations—rather than just current circumstances—are what drive equity markets. Investors appear to think that Japan’s listed companies have greater long-term value than the GDP headline suggests, especially in the manufacturing, automotive, and electronics component sectors.

After hanging over Japanese finance like a ghost for thirty-four years, the Nikkei 225 finally reclaimed and surpassed its fabled 1989 peak. It felt important to see that psychological barrier come down. Not exactly victorious, but meaningful in a difficult-to-quantify way.

Foreign currency has contributed to this. After years of regulatory uncertainty and geopolitical tension, many international investors have shifted their focus toward Japan as they reevaluate their exposure to China.

Paradoxically, buyers with dollars or euros found Japanese stocks to be inexpensive due to the weakening yen, which caused the GDP figures to decline when expressed in dollars. In 2023, a foreign fund manager considering a manufacturer listed in Tokyo was effectively receiving a discount. A large number of them accepted it.

When you take a moment to consider the currency story, it becomes truly bizarre. Japan’s nominal GDP increased by roughly 7.5% from 550 trillion yen in 2012 to almost 592 trillion yen in 2023. Not spectacular, but respectable. However, if you convert those same numbers into dollars, you get a decrease of about 39% over the same time frame.

The yen’s decline from roughly 79 to the dollar in 2012 to 140.5 in 2023 completely changed Japan’s position in the world economy. The GDP reversal between Germany and Japan most likely would not have occurred in the absence of the exchange rate collapse. This implies that the GDP comparison is, at the very least, skewed, but it does not eliminate the structural issues.

The sustainability of the market outperformance and whether it is based on a currency-driven illusion that will collapse if the yen appreciates significantly are still up in the air. Any significant rate normalization will alter the calculations for foreign investors who came in part for the currency discount, and the Bank of Japan has started cautiously retreating from its ten-year experiment with ultra-loose monetary policy.

There is a feeling that the current euphoria in Tokyo’s financial district, which is evident in the increased activity on Kabutocho and the renewed interest from foreign brokerages, could be susceptible to a change in the macroenvironment.

However, it is more difficult to overlook the bigger picture. Over the past ten years, Japanese businesses have quietly undergone significant reform. Long-promoted by the Tokyo Stock Exchange itself, corporate governance reforms have forced businesses to deal with extensive cross-shareholding arrangements and give shareholders a larger return on investment.

Businesses that used to hoard massive sums of money without any justification are now under pressure to either distribute or justify those reserves. It’s possible that markets are just now starting to fully reflect that kind of structural change, which tends to be priced in slowly.

Beneath the surface, there are still serious issues. Between 2000 and 2022, nominal wage growth in Japan averaged only 0.2 percent per year, while it was 2.2 percent in Germany and 3.3 percent in the US.

Low wages stifle domestic consumption, which restricts growth and prevents businesses from making money in the domestic market. By 2022, the nation’s share of the global GDP had dropped from a peak of almost 18% in 1995 to roughly 4%. It takes time for that trajectory to change.

However, it is difficult to ignore the fact that the GDP tables convey a different message than the Japanese stock market’s ascent above Germany’s. Markets are forward-looking, sometimes irrationally so and frequently imperfectly so. However, the fact that international investors are currently favoring Tokyo over Frankfurt and putting actual money on that decision speaks volumes about the state of confidence.

The real question is whether Japan can convert that financial market optimism into real wage growth, innovation capacity, and demographic resilience. The stock market has placed its wager. The economy still needs to improve.