Authors: Julia Wang, Cameron Chui, Yuxuan Tang, Weiheng Chen
What we think
A July hike from the BoJ is not our base case, nor do we expect a hike for the rest of 2024. We think a BoJ that can take interest rate normalization in a gradual and controlled manner is positive. From a fundamental perspective, given our base case for moderate reflation and gradual policy normalization, we continue to have a positive outlook on Japan’s economy.
Investment implications
On the currency, a gradual pace of Fed rate cuts and BoJ normalization means it could take some time before the USDJPY carry becomes less punitive for investors and corporates to start accumulating the yen, meaning it might be still too early to turn bullish on the yen. We propose FX-hedging Japan equity positions to earn a carry and hedge yen risks.
With Japanese equities having rallied into the earnings season, the bar for share prices to rise on solid earnings is clearly higher. Volatility around earnings results could offer opportunities to add exposure to stocks that are overbought in the short-term. We are positive on Japanese equities as the market could potentially offer mid-high single digit returns over the next 12 months. Small 3-4% pullbacks in the broader market could also present buy-the-dip opportunities.
Japanese economic data has continued to show normalization in recent months, with resilient inflation and strong wage growth prompting a growing chorus of calls for the Bank of Japan (BoJ) to continue accommodating policy after a historic exit from negative rates in March. The very gradual pace of policy normalization so far has led to persistent weakness in the yen (down over 10% against the dollar this year), giving more fodder to those calling for a hike to arrest excessive depreciation and the risk of imported inflation.
As markets remain split over whether the next BoJ meeting on July 30-31 will produce another hike, investors appear bullish about the prospects for Japanese equities, which have rallied around 25% this year to reach new all-time highs. However, as we approach the upcoming earnings season following the record rally alongside bouts of yen strength as U.S. easing nears, could this constructive equity view be impacted? Over the longer-term, we also question whether Japan’s structural economic challenges can continue to support the case for monetary policy to remain fundamentally accommodative – as they have for decades – or will this reflationary cycle finally lead policymakers to normalize for good?
JAPAN IS BREAKING OUT OF A DECADES-LONG RANGE OF LOW NOMINAL GROWTH AND NEAR-ZERO INTEREST RATES
This line chart shows Japan’s nominal GDP, Bank of Japan policy rate and policy rate expectation from 1984 to 2024. The 3 data sets are shown in aqua, dark blue and orange lines respectively. On nominal GDP, the graph shows that from 1984 to 1996, nominal GDP was in an upward trend. From 1996 to 2022, nominal GDP has remained on average stagnant except for a few downturns in 2008 and 2020. After 2022 and as a benefit of reflation, Japan’s nominal GDP returned to a growing trend. Japan’s policy rate saw wild swings before the 2000s. Policy rate decreased from 5% to 2.5% and then increased to 6.0% between 1984 and 1990. After the 1990s, Bank of Japan’s policy rate steadily decreased to near 0 by the 2000s. Between 2000 and 2016, Bank of Japan policy rate has stayed sub 0.5% with little changes. After 2016, policy rate became negative and stayed negative until 2024. Given nominal GDP is seeing growth again, policy rate expectations show that investors think policy rate will continue to rise and normalize.
In this week’s Asia Strategy Focus we address the BoJ’s rate hike debate and assess the implications of that discussion on the Japanese yen and equity market.
To hike?
In our view, there are good arguments for rate hikes in the coming year, but none for an imminent hike in July. The strongest argument for hiking as soon as the July meeting would be related to the currency – in other words, to pre-emptively limit the potential cost of further JPY weakness. In this regard, any sign of two-way risks around JPY helps to lessen the urgency of hiking. For context, the BoJ does acknowledge currency weakness as a risk. We think there are two aspects to this debate.
First, a repeat of 2022 – a year when oil prices jumped from below $80 to above $120 alongside a weakening of the JPY to the tune of 30% – would clearly be unwelcome should it occur right now, with baseline inflation already at 2%.
Second, in addition to upside inflation risks, a weak currency has distributional implications. While Japan’s exporters benefit from a weak JPY, importers and consumers lose from it. On net, the economy as a whole benefits slightly because corporates are likely to pass on some of the gains via higher wages, particularly in this cycle. But the transmission takes time, and public perception can take an understandably negative view on currency weakness in the meantime. To be clear, while the BoJ has acknowledged the risk, they are open-ended about how they plan to deal with it. We are skeptical that monetary policy should be used to influence the exchange rate for an economy like Japan. Emerging markets have sometimes done so with mixed results.
The second, weaker argument for hiking in July would be for the BoJ to prove a point. As the central bank is preparing to start reducing bond purchases in July, general market consensus is that they are unlikely to hike at the same time. The BoJ might not appreciate being seen as having their hands tied, and might want to prove they have full policy flexibility. We don’t think investors should be overly concerned about this, as central banks rarely make policy moves just for the sake of it. In addition, they generally have other ways to nudge market expectations. So while this is a good reason to keep the meeting ‘live’ in the mind of investors, it is not a strong argument for actually hiking.
Or not to hike?
So what are the arguments for why July is not a good time to hike? The main reasoning is that a hike at this point is premature given where we are in the growth cycle. From a cyclical perspective, Japan’s economic growth has slowed in 2024, even as it did narrowly avoid a recession. The main growth driver at the moment is the corporate sector, which is reporting higher profits, strong export growth, and a positive capex outlook. All of these are on full display in the equity market, where earnings outlooks are still being revised higher. But the positive vibe isn’t shared broadly, as consumers have taken the brunt of inflation over the last two years. Consumers are just starting to recover from this inflation shock thanks to stronger wage growth. Nominal wage growth accelerated to 2.7% in June, and we have positive expectations that wage growth can settle in the 3-4% range by the end of 2024. That said, it will likely still take time for consumer sentiment to improve, as reflected in the soft consumption data.
REAL CONSUMPTION IN JAPAN HAS BEEN SOFT DUE TO INFLATION
Consumption activity, adjusted for tourism, indexed 2015=100 (Y-Axis)
This line chart tracks consumption activity in Japan, adjusted for tourism. The dark blue line represents real consumption activity while the aqua line represents nominal consumption activity. The dark blue and aqua dotted lines show consumption activities before the pandemic with 2015 indexed at 100. Between 2020 and 2022, the graph shows that nominal and real consumption activities have stayed closely correlated. After 2022, however, there is a divergence between real consumption activity and nominal consumption activity. Nominal consumption activities have increased to above pre-pandemic trends due to a rise in inflation. However, real consumption activities have stayed below pre-pandemic trends, as real wage growth lags inflation.
A rate hike at this juncture will likely do very little to incentivize more spending, and consumers may feel worse as it raises their mortgage costs.
On a related point, Japanese inflation has been falling over the last few quarters, and the near-term trajectory does not suggest an imminent rebound. Some analysts are pointing to the energy subsidy removal as a reason to see a step-up in inflation in the summer, but such a well-flagged and temporary factor isn’t likely to influence the path of underlying inflation, which is what matters for the economy. When we zoom out to look at the broader inflation trend, it is falling rather than rising, with consumer-led inflation near troughs rather than peaks. That means a rate hike now would actually be mis-aligned with the underlying inflation cycle. While we expect Japanese inflation to stay positive in the coming years – a stark contrast with its deflationary decades – it has to show strong signs of overheating to warrant brisk rate hikes.
JAPAN’S BROADER INFLATION TREND IS FALLING RATHER THAN RISING
Core CPI, year-over-year % (Y-Axis)
This line chart shows Japanese core CPI changes YoY since 1990 in relation to the Bank of Japan inflation target at 2.0%. The chart shows that core CPI in Japan has only on very few occasions stayed at the Bank of Japan’s inflation target at 2.0%. In the 30 years between 1990 to 2020, Japan has mainly been under periods low inflation or deflation. Japan’s inflation picture completely changed after 2020 as core CPI skyrocketed from negative territory in 2021 to above 4.0% in 2023. Ever since core CPI peaked in mid-2023, inflation has been on a steady falling trend and is nearing the Bank of Japan’s inflation target of 2.0%. The Bank of Japan believes that core CPI will stay near their inflation target in 2024 and beyond, as represented by the dotted orange line.
Lastly, some commentators have highlighted the issue of debt sustainability. Japan’s high ratio of government debt-to-GDP (over 250%) is well known. Given the average debt duration of just slightly under 10 years, the fiscal sustainability picture does come into view whenever the BoJ’s interest rate policy is discussed.
We would caution against assuming the fiscal situation has any immediate bearing on the policy rate. Instead, the broader argument is better focused on how it further underlines the policy consensus that reflation is one of the only ways to outgrow the debt trap. If a premature rate hike creates risks to a more sustainable recovery then it should be delayed until a more appropriate time.
The bottom line
Weighing the arguments for and against, a July hike from the BoJ is not our base case, nor do we expect a hike for the rest of 2024. The timeline for rate hikes will likely depend on two variables and a risk factor.
The first variable is when Japanese consumption can show greater strength. Normally, consumption lags wage growth, so that may push the timeline for a first hike into 2025. The second variable is demand-driven inflation, particularly in the service sector. This is the official criteria for a rate hike – and is expressed as the “virtuous reflationary cycle” by policymakers. From a risk perspective, we will obviously keep an eye on the currency.
Over the last six months, many investors have read about our positive view on Japan, particularly its medium-term reflation prospects and what it means for the equity market (interested readers can find these reports here: Japan: Is this time different?; Japan: capitalizing on the pullback; Asia Mid-year Outlook 2024: Rising optimism but risks on the horizon).
Our discussions on the cyclical reasons why we don’t see a July rate hike doesn’t change our medium-term outlook. In fact, we think a BoJ that can take interest rate normalization in a gradual and controlled manner is positive. Investors need only look at the Japanese Government Bond (JGB) market to see how the BoJ has deftly handled policy rate normalization. Since the exit from Yield Curve Control, JGB yields have climbed higher without derailing the economy. Japanese markets often see heightened volatility on BoJ meeting days, and we could see some market fireworks around this meeting as well. But from a fundamental perspective, given our base case for moderate reflation and gradual policy normalization, we continue to have a positive outlook on Japan’s economy.
JPY: carry is the story
Naturally, any discussion on Japan’s economy would warrant a discussion on the currency. The yen has been under significant depreciation pressure this year. With the BoJ likely staying patient on policy normalization as discussed, carry-trade induced outflows have continued to build up. Since Q2, we have seen two episodes of direct FX intervention from the Ministry of Finance (MoF) and/or the BoJ, aiming to stabilize the currency market, with the latest operation in July suggesting a shift in intervention strategy. As a result, more questions are raised on the currency outlook – we unpack the recent developments and offer our take.
We do think that Japanese authorities are turning more proactive on their FX management strategy. Historically the MoF has adhered to a few quantitative thresholds – mainly the magnitude of short-term moves in the currency – in their decisions to intervene. This approach is focused on defending the yen against sharp depreciations. However, the latest operation in July seemed to be playing more offense than defense; authorities used the USD selloff caused by the U.S. CPI data surprise to their advantage and magnified its price impact on the yen. One possible reason could be related to concerns over the fact that the yen has been clearly diverging from its “fundamentals”, especially after the April/May intervention, with USDJPY grinding higher even as interest rate differentials narrowed. The chart below illustrates how the pair has stopped tracking traditional macro variables.
USDJPY HAS RECENTLY OVERSHOT FUNDAMENTALS
This line chart shows the relationship between the USDJPY exchange rate and the 10- year U.S. Treasury-Japan Government Bond spread. USDJPY exchange rate, represented by the aqua line, has recently exceeded 160 in recent weeks, diverging from its fundamental value relative to the 10-year U.S. Treasury-Japan Government Bond spread. The 10-year bond spread is represented by the dark blue line. Historically, these two metrics have closely followed each other. From January 2022 to April 2024, both the bond spread and the USDJPY rate generally trended upwards. The bond spread increased from 1.5% to over 3.5%, while the USDJPY rate rose from around 115 to approximately 155. Recently, however, while the bond spread has declined to slightly over 3%, USDJPY exchange rate continued to rise. This shows a break from historical trends.
The July intervention could be an effort to proactively squeeze ‘speculative shorts’ to guide the currency market back to fundamental drivers.
Having said that, the impact of unilateral FX interventions are usually short-lived. While Japan has ample reserves at its disposal, FX interventions are costly and almost never a sustainable solution. Fundamentally, the deeply negative carry against the dollar has been the key reason behind yen weakness, and small moves in carry have historically not been sufficient to support the yen in a significant way.
If a BoJ rate hike is not imminent, the Fed will likely continue to be in the driver’s seat in determining the yen’s fate. After last week’s CPI, the bar seems high for the Fed to move faster than what the market currently anticipates (i.e. more than two cuts this year). Short of a meaningful deterioration in the U.S. economy, the pace of cuts will likely remain gradual, which means it could take some time before carry becomes less punitive for investors and corporates to start accumulating the yen. All of these tell us that it might be still too early to turn bullish on the yen.
Investors could potentially consider FX-hedging Japan equity positions in order to earn a carry and hedge against FX risks.
Equities: beatable expectations
Heading into the FY1Q25 Japanese earnings season, we believe that consensus expectations are relatively conservative and beatable. Sales are expected to grow 6.4% YoY, a slight acceleration from the 4% growth rate in the prior quarter. With manufacturing activity levels improving relative to the prior quarter, and USDJPY having weakened 12-13% on a year-on-year basis, sales growth expectations are very achievable, in our view. Operating profit is expected to grow at just 4.8% YoY, with margins expected to slightly contract on a YoY basis. This seems too conservative and we expect at least high-single-digit operating profit growth, and potentially low-teens earnings growth.
Guidance provided at FY24 results indicate 0% recurring profit growth, which is likely to prove conservative. While it is not normal for Japanese management teams to revise earnings forecasts so early in the fiscal year, the persistently weaker yen does leave scope for some positive adjustments purely driven by currency effects.
Investors will likely also be paying close attention to current trading conditions and the order book outlook for both industrial and semiconductor companies. Positive commentary on improvements or inflections in manufacturing end-demand will likely be taken positively. Companies with meaningful inbound tourism spend sensitivity could also see upside to revenues and profits. Any capital management announcements to either raise dividends or share buybacks will likely also be well-received, but is not expected at this time of the year – we have already seen some corporate actions initiated after the AGM season.
With Japanese equities having rallied into the earnings season, the bar for share prices to rise on solid earnings is clearly higher. Volatility around earnings results could offer opportunities to add exposure to stocks that are overbought in the short-term.
We maintain our positive view on the Japanese equity market with a June 2025 TOPIX outlook of 3,025-3,125, offering mid-high single digit returns. This is based on a forward P/E multiple of 15-15.5x, and earnings that we expect to grow 10-11% over the next 12 months. In particular, we see opportunities in Industrials, Real Estate, Consumer Electronics, and Financials. Small 3-4% pullbacks in the broader market offer opportunities to buy the dip.
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Index definitions
Tokyo Stock Price Index, commonly known as TOPIX, along with the Nikkei 225, is an important stock market index for the Tokyo Stock Exchange in Japan, which tracks the entire market of domestic companies and covers most stocks in the Prime Market and some stocks in the Standard Market.
