Where does Japan go from here?

Authors : Julia Wang, Cameron Chui, Yuxuan Tang, Weiheng Chen

What we think

In our view, the near-term risks from Japan’s policy normalization, the carry trade unwind and technical factors do not invalidate the structural investment thesis for Japanese equities. This unwinding could allow investors to focus more on market fundamentals over the medium to longer-term, on which we remain positive.

Investment implications

While yen strength and increased global economic uncertainty has impacted our base case outlook by 8-9%, we view the selloff as being overdone relative to fundamentals. Many companies approached valuation multiples (on a price-to-book basis) last seen during the depths of COVID-19. We view the TOPIX at 2,200-2,300 as a level consistent with a near-recessionary environment and for investors to add positions aggressively. We believe that the structural opportunity in Japan remains, in view of its more reflationary path and corporate governance changes in the years ahead.

On a longer time horizon, the yen still appears somewhat undervalued given interest rate differentials. With U.S. yields likely to decline with softening growth and a more aggressive Fed cutting cycle, we see the pair staying range-bound around current levels going into the end of the year and strengthen modestly by the middle of next year.

 

The Bank of Japan (BoJ) hiked its policy rate from 0.1% to 0.25% on July 31^st, a move which surprised consensus expectations but was acknowledged as a risk by forecasters. What was perhaps less expected was the global market rout which ensued in the following days, at one point bringing USDJPY below 142 (from over 160 less than a month ago) and crashing Japanese equities nearly 25% from all-time highs (also less than a month ago), marking record single-day declines and volatility spikes. In what could already be a sign that policymakers are acknowledging the challenges of rate normalization, the BoJ’s Deputy Governor Shinichi Uchida recently stated that the central bank “will not raise its policy interest rate when financial and capital markets are unstable". As the BoJ takes on the challenge of sustaining Japan’s long-awaited reflation while normalizing decades of ultra-easy monetary policy, global positions that have been built up using borrowed yen, the fundamental macro risks of making such a structural shift, and technical market factors can continue to introduce volatility.

Even as markets have since pared some of those extreme moves, questions and concerns remain over Japan’s path from here. How much is left of the “carry trade” where investors borrowed the yen at low interest rates to invest into higher-yielding assets? Is the era of a weak yen and strong equity performance over?

In this week’s Asia Strategy Focus, we address those questions and update our views on Japan, with the perspective that fundamentals will likely dominate over the medium to longer-term, but positioning and technical factors could have an impact in the near-term. We reiterate our constructive outlook on Japan’s economy and markets even as risks remain.

How much is left of the “carry trade”?

First, what is a carry trade? Simply put, investors conduct a carry trade by borrowing in a low-interest rate currency (such as the yen or Swiss franc) and investing the funds in a higher-yielding currency (such as the U.S. dollar). The basic return from this trade is the difference in interest rates between the two currencies. Borrowing in yen to fund investments in dollar assets such as U.S. stocks and bonds and Japanese equities (among many others) has been popular as global interest rates rose while Japan’s stayed firmly anchored at low levels.

However, things can unravel quickly. When the funding currency appreciates (which the borrower has a short position on), investors may be forced to sell their long positions to cover losses on their short positions. In this case, the yen has been steadily appreciating against the dollar since July 11^th (when Japanese authorities intervened to prop up the currency) and its strength accelerated after the BoJ’s rate hike on July 31^st. As investors covered losses on their short yen positions (by buying yen) it pushed the currency higher, creating a feedback loop. But it wasn’t just the currency – many participants invested their borrowed yen into equities as well. Those leveraged investors sold other assets (such as U.S. or Japanese equities) to cover their yen losses too. The selloff in equities also intensified the negative feedback loop.

So naturally the next question is how much of the carry trade has been unwound, and how much is left? Unfortunately, there is no definitive answer as currency transactions aren’t tracked centrally on an exchange. Estimates range from $20 trillion (courtesy of Deutsche Bank, making the case that the consolidated balance sheet of the Japanese government and related entities are engaged in a massive carry trade) to $1 trillion based on Japanese banks’ foreign lending.

In terms of estimating how much of the trade has been unwound, some strategists including those from J.P. Morgan Investment Bank are pointing to around 50% based on speculative yen short positions. The latest data on speculative yen shorts is as of end-July, and the most recent week’s activity suggests the unwinding could be even larger.

In terms of equity flows, J.P. Morgan Investment Bank estimates that most of the year-to-date net buying of Japanese equities have been reset and long positions added by foreign investors over the past 15 months have been almost entirely unwound. This sets Japan up favorably from a positioning perspective and further highlights the likelihood that the selloff was overdone.

Whatever the ultimate magnitude of the carry trade is, it appears unlikely that the full extent of the unwinding has been realized, meaning the risk of further spikes in volatility remains should fundamental pressures continue to drive USDJPY sharply lower and result in more capitulation. However, as markets stabilize, carry investors would be unlikely to reestablish their positions with the same magnitude as before given the rising risks of a U.S. macro slowdown and narrowing of rate differentials relative to Japan, which is still the key fundamental driver of the currency pair over the longer-term.

Is yen weakness over?

As for where we see the yen going, fundamental drivers are likely to reassert themselves as the key driver in the wake of the carry trade washout. USDJPY overshot fundamentals implied by U.S. Treasury yields in last couple of months, but the recent moves have wiped out the so-called “carry trade premium” and brought levels more in-line with fundamentals. Volatility is likely to remain a risk as these carry trades may not have been fully unwound, but any significant overshoots in yen strength beyond fundamentals could be opportunities to establish hedges which are still providing ~4% of carry to investors.

On a longer time horizon, the yen still appears somewhat undervalued given interest rate differentials. With U.S. yields likely to decline with softening growth and a more aggressive Fed cutting cycle, we see the yen staying range-bound around current levels going into the end of the year and strengthen modestly by the middle of next year. Unless the U.S. macro outlook deteriorates meaningfully (which we are not expecting), we are unlikely to see further bouts of extreme yen strength.

Why do we still like Japanese equities?

Japan remains our favored equity market in Asia and one of our preferred markets globally. Corporate Japan has been in good health with earnings tracking +12% YoY this quarter, and no meaningful signs of a deterioration in the outlook. Ongoing structural changes in the macro environment based on sustainable reflation mean that Japan’s equity market valuations have favorable re-rating potential.

Whilst the recent yen strength and increased global economic uncertainty have led us to lower our June 2025 TOPIX outlook by 8-9%, we view the selloff as being overdone relative to fundamentals. Many companies approached valuation multiples (on a price-to-book basis) last seen during the depths of COVID-19. We view the TOPIX at 2,200-2,300 as a level consistent with a near-recessionary environment and for investors to add positions aggressively. We believe that the structural opportunity in Japan remains, in view of its more reflationary path and corporate governance changes in the years ahead.

While volatility is likely to remain in the market, we are at attractive price levels to consider legging into Japanese equities or using derivatives with meaningful upside participation while incorporating downside hedging. On a multi-month and multi-year basis, we expect the equity market to be higher. Some sectors which look especially attractive at the moment are companies domestically oriented with minimal foreign currency exposure; and export-oriented names trading near recessionary valuations. 

Over the longer-term, we continue to see opportunities in Financials (on continued reflation), Consumer Discretionary (on a consumption recovery led by higher wage growth), Technology (on AI-related beneficiaries such as in semiconductors), Industrials (on a bottoming global manufacturing cycle) and Real Estate (on upside from asset revaluation, sales and higher rents).

What are the risks to our constructive view?

The negative impact of a stronger yen on equities was apparent in the selloff. Japanese equity investors are rightfully concerned about the traditionally inverse relationship between the two. Any further strength from current levels will likely remain a headwind for Japanese export-oriented corporate earnings.

Another key risk which has been introduced to the market suddenly is that of a slower than expected U.S. economy. July employment data showed the U.S. labor market weakening faster than expectations, which raised recession concerns. Confidence in a soft landing had become such an overwhelming consensus view by the middle of this year that financial markets were not positioned for any disappointments. This current ‘growth scare’ we are witnessing in the U.S. will likely be negative for Japan’s manufacturing-led economy and could weigh on valuation multiples for more cyclical markets like Japan until we get more clarity on the extent of the slowdown.

Taken together and barring any offsetting changes, these risks would likely further moderate the upside for the TOPIX.

The other risk is how the BoJ manages monetary policy going forward and whether they could prematurely choke off Japan’s reflation progress by tightening too quickly. In addition, the negative impact of non-consensus policy moves on the market (evidenced by the selloff) could result in second-order effects of a loss of confidence and drag on consumption and investment, a risk acknowledged by policymakers. While in retrospect the BoJ’s rate hike in July appears to have done more damage than good to the market, it was mostly due to poor timing, unclear communication, and unpredictability. A structurally more reflationary Japan can live with a higher interest rate, so long as rate increases are well-paced, clearly communicated, and happen in a gradual way. In a way, the sharp strengthening of the yen has also done the heavy lifting for the BoJ in terms of addressing the growing social and political dissatisfaction with persistent currency weakness, with markets expecting almost no hikes for the rest of the year.

In our view, these risks do not invalidate the structural investment thesis for Japanese equities (as we have outlined here, here and here). While near-term worries over the carry trade could continue to introduce market volatility, this unwinding could allow investors to focus more on market fundamentals over the medium to longer-term, on which we remain positive.

All market and economic data as of August 8, 2024 and sourced from Bloomberg Finance L.P. and FactSet unless otherwise stated.

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Index definitions

The Nikkei Stock Average Volatility Index is calculated by using prices of Nikkei 225 futures and Nikkei 225 options on the Osaka Securities Exchange.

The TOPIX, also known as the Tokyo Stock Price Index, is a capitalization-weighted index of all companies listed on the First Section of the Tokyo Stock Exchange. The index is supplemented by the subindices of the 33 industry sectors. The index calculation excludes temporary issues and preferred stocks, and has a base value of 100 as of January 4, 1968.