Dear Shareholder
Most major global stock and bond indexes produced positive results during your fund's fiscal year, the 12-month period ended October 31, 2023, although a downturn over the past six months offset some of the strong gains recorded in the first half of the period. Global economies managed to avoid the recession that was widely predicted at the start of 2023, but signs that central banks might need to keep interest rates higher for longer than previously expected weighed on market sentiment.
Growth stocks outperformed value shares over the 12-month period, and stocks in developed markets generally outpaced their counterparts in emerging markets. Currency movements were mixed over the period, although a weaker dollar versus major European currencies was beneficial for U.S. investors in European securities.
Technology companies benefited from investor enthusiasm for artificial intelligence developments and produced some of the strongest results in the equity market. Within the S&P 500 Index, the communication services and information technology sectors were lifted by the rally in tech-related companies and recorded significant gains. The financials sector partly recovered from the failure of three large regional banks during the period but still finished in negative territory.
Corporate fundamentals were broadly supportive. Although year-over-year earnings growth contracted in the first and second quarters of 2023, results were better than expected, and preliminary estimates pointed to a resumption of growth in the third quarter.
The U.S. economy was the strongest among the major markets during the period, with gross domestic product growth coming in at 4.9% in the third quarter's initial estimate, the highest since the end of 2021. Growth in Europe and Japan was more sluggish, and China's economy was beset by worries about its property sector after an initial boost from its decision at the end of 2022 to lift most of its pandemic-related restrictions. A protracted debt ceiling standoff in the U.S., the ongoing conflict between Ukraine and Russia, and the outbreak of war in the Middle East following the attack on Israel by Hamas produced headwinds for markets at various times.
Investors also remained focused on inflation as price increases moderated but remained well above the Federal Reserve's 2% target. In response, the Fed continued to raise its short-term lending benchmark rate, lifting it to a target range of 5.25% to 5.50% by the end of July, the highest level since March 2001.
U.S. Treasury yields increased as the Fed tightened monetary policy and investors priced in the possibility that the central bank may have to keep rates higher for longer than previously anticipated. In addition, Treasuries were pressured by Fitch Ratings' decision to downgrade the credit rating of U.S. government debt from the highest level, AAA, to AA+ along with expectations for higher levels of borrowing by the Treasury Department. The yield on the benchmark 10-year Treasury note briefly reached 5.00% in October for the first time since late 2007 before falling back to 4.88% by period-end.
Increasing yields over the past six months led to weak results across most of the fixed income market, although high yield bonds, which are less sensitive to rising rates, held up relatively well as default rates remained low by historical standards.
Global economies and markets showed surprising resilience in 2023, but considerable uncertainty remains as we look ahead to 2024. Geopolitical events, the path of monetary policy, and the impact of the Fed's rate hikes on the economy all raise the potential for additional volatility. We believe this environment makes skilled active management a critical tool for identifying risks and opportunities, and our investment teams will continue to use fundamental research to identify securities that have the potential to add value to your portfolio over the long term.
Thank you for your continued confidence in T. Rowe Price.
Sincerely,
Robert Sharps
CEO and President
INVESTMENT OBJECTIVE
The fund seeks long-term growth of capital through investments in common stocks of companies located (or with primary operations) in Japan.
FUND COMMENTARY
How did the fund perform in the past 12 months?
The Japan Fund returned 0.22% in the 12-month period ended October 31, 2023. As shown in the Performance Comparison table, the fund underperformed its benchmark, the TOPIX Index Net, and the Lipper Japanese Funds Average. (Returns for I and Z Class shares varied slightly, reflecting their different fee structures. Past performance cannot guarantee future results.)
What factors influenced the fund's performance?
Japanese equities continued their strong run over the 12 months. Gains were driven by favorable domestic economic developments, strength in corporate earnings, weakness in the yen, the Bank of Japan's highly accommodative monetary policy, and signs of progress on corporate governance reform at the company level.
However, the fund lagged its benchmark due to unfavorable stock selection and, to a lesser degree, sector allocation. The fund continued to face style headwinds, with weakness in the yen as well as the outperformance of large-cap companies and value stocks all hurting relative returns over the period. This was partly due to the fund not owning many of the large-cap exporters that benefit from the weak yen and also because we were underweighting value stocks and overweighting growth and quality companies for much of the period.
Stock selection and our positioning in electric appliances and precision instruments, where we were overweight for much of the period before moving underweight more recently, detracted the most. Security choices and our above-benchmark holding in information technology (IT) and services also weighed. On the positive front, our underweight allocation to transportation and logistics boosted relative returns.
Within electric appliances and precision instruments, shares of Lasertec (TSE:6920, Financial), a semiconductor production equipment company with a monopoly in the testing of extreme ultraviolet lithography masks, underperformed after disappointing orders. Medical technology company Olympus (TSE:7733, Financial), a leader in gastrointestinal endoscopes, also lagged. The firm reported weaker-than-anticipated operating profits, due in part to slower sales of high-margin products. Vision and laser equipment business Keyence (TSE:6861, Financial) was another key detractor as a result of China's weaker growth. In contrast, positive contributors within the sector included Hitachi (TSE:5812, Financial). The conglomerate, which engages in the manufacture and sale of electrical equipment, gained on solid results. (Please refer to the portfolio of investments for a complete list of holdings and the amount each represents in the portfolio.)
In the IT and services sector, e-commerce leader GMO Payment Gateway (TSE:3769, Financial) struggled on some concerns about its ability to sustain high-growth momentum. Solasto (TSE:6197, Financial), a key player in the staffing and operational outsourcing market for medical institutions, weighed on relative returns, due in part to the limited progress it has made in mergers and acquisitions, in particular relating to its elderly care business. Conversely, positive contributors within the sector included Hikari Tsushin (TSE:9435, Financial). The firm, which engages in the reselling of subscription-type products and services, reported consensus-beating earnings for the second straight quarter.
Among machinery names, Disco, a manufacturer of cutting and grinding tools used across industries including semiconductors, benefited from growing silicon carbide investment and increased artificial intelligence-related demand.
How is the fund positioned?
As mentioned earlier, the fund was positioned underweight value and overweight growth and quality for much of the period. However, in the third quarter of 2023, we reduced some of the portfolio's factor risk exposures, primarily our underweight allocation to the value factor, and retained our growth exposure. Against a globally changing market environment, but especially in Japan, we want to position the portfolio to allow for our fundamental stock selection to add value once again—this is where we believe we have an edge. We added to some value names that are embracing corporate governance reform and consolidated some of our defensive exposure.
The fund is positioned overweight raw materials and chemicals, energy resources, and IT and services, while below-benchmark allocations include transportation and logistics as well as commercial and wholesale trade and foods.
During the review period, we found attractive investments with idiosyncratic drivers in the automobiles and transportation equipment sector. We established a holding in Honda Motor (HMC, Financial), a global manufacturer of automobiles and motorcycles, at an attractive valuation. It is buying back stock and has, in our view, one of the better upcoming model cycles. We also added a position in Toyota Industries (TSE:6201, Financial), a stable business focused primarily on forklifts and other material handling equipment. Our investment thesis is predicated on the trend toward improved balance sheet efficiency at the Toyota Group level.
We moved underweight the electric appliances and precision instruments sector. We sold our holding in electronic products manufacturer Panasonic (TSE:4283, Financial) to lock in profits. We also had concerns about management's limited willingness to restructure the company. We exited our position in Lasertec, mentioned earlier, given our view that consensus expectations for revenue growth are too high.
Within IT and services, we took advantage of share price strength and sold our holding in video game company Nintendo (TSE:7974, Financial) following the successes of its key franchises, The Super Mario Bros. Movie and The Legend of Zelda game.
In the raw materials and chemicals sector, we established a position in consumer and chemical products company Kao (TSE:4452). Its management has embarked on a restructuring, and we expect a rationalization of the company's brand portfolio. We also added a holding in Shin-Etsu Chemical (TSE:4063), which operates globally in PVC (or vinyl used in housing and construction), semiconductor materials, and rare earth magnets. In our view, it is a good business operating in a structurally improved competitive environment and facing imminent earnings upcycles.
What is portfolio management's outlook?
Signs of a sustainable return of inflation in Japan are extremely encouraging and likely a huge boost for investor and business sentiment. As inflation has ticked higher in Japan, wage hikes have started to come through, which should be very supportive for the consumer and domestic consumption. These wage increases have been primarily in the large-cap sectors for now, but we believe medium-sized and smaller companies will follow their lead.
Increasing inflation is also forcing Japanese corporate executives to question the excess cash on their balance sheets as the time value is eroded. Japanese corporates are buying back stock and returning capital to shareholders at record levels. As corporate governance reforms continue to make headway, we expect to see higher returns on capital, which is positive for the health of Japanese companies and signals the ongoing improvement in governance at the company level.
Furthermore, long-term secular trends like growth in factory automation, the use of robotics, and vehicle electrification are highly supportive of many Japanese industries.
Although a potential U.S. recession would likely present considerable headwinds for Japanese equities due to the export-oriented nature of the economy, we believe much of the risk is already reflected in company valuations. This creates opportunities for bottom-up, fundamental investors to find quality businesses at reasonable prices.
The views expressed reflect the opinions of T. Rowe Price as of the date of this report and are subject to change based on changes in market, economic, or other conditions. These views are not intended to be a forecast of future events and are no guarantee of future results.
