Investment Strategy

Where does Japan go from here?

Aug 9, 2024
Authors : Julia Wang, Cameron Chui, Yuxuan Tang, Weiheng Chen


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.

While yen strength and increased global economic uncertainty increases downside risks to the outlook, 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 exposure at these levels. 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 31st, 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.

JAPAN’S EQUITY VOLATILITY SURGED TO SOME OF ITS HIGHEST LEVELS EVER AND THE MARKET LOST OVER A TRILLION DOLLARS IN VALUE

Source: Bloomberg Finance L.P. Data as of August 7, 2024.
The chart shows the Nikkei Volatility Index (left axis) and Japan Exchange Market Cap in USD trillions (right axis) from 2004 to 2024, demonstrating the inverse relationship between market volatility and market capitalization in Japan. During periods when the Nikkei VIX spikes, the Japan Exchange Market Cap often shows a decline during these volatility spikes, implying a market sell-off.

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.

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 11th (when Japanese authorities intervened to prop up the currency) and its strength accelerated after the BoJ’s rate hike on July 31st. 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.

SPECULATIVE YEN SHORT POSITIONS HAVE STARTED UNWINDING

Source: Commodity Futures Trading Commission (CFTC), Chicago Mercantile Exchange (CME), Bloomberg Finance L.P. Data as of July 30, 2024.
The chart plots the Commodity Futures Trading Commission (CFTC) Chicago Mercantile Exchange (CME) JPY short positions (left) against the USDJPY exchange rate (right), illustrating the correlation between speculative short positions on JPY and USDJPY. When JPY short positions increased from 72241 in January 2023 to 158021 in November 2023, USDJPY increased from 132.08 in January 2023 to 149.63 in November 2023. This was followed by a fall in JPY short positions to 92889 in December 2023 and during the same period, USDJPY fell to 141.04. From December 2023 to June 2024, JPY short positions have been on a steady uptrend, increasing from 92889 in December 2023 to 208476. USDJPY increased from 141.04 in December 2023 to 160.88 in June 2024. In July 2024, speculative JPY short positions started to unwind, falling from 220937 in the start of the month to 138476 by the end of the month. USDJPY plunged from a peak of 160.88 to 146.53 as of July 30, 2024.

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.

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.

USDJPY CORRELATION WITH RATE DIFFERENTIALS MAY COME BACK

USDJPY vs model implied level

Source: J.P. Morgan Private Bank, Bloomberg Finance L.P. Data as of August 7, 2024. UST = U.S. Treasuries. 
This line chart shows the relationship between the USDJPY exchange rate and the fair value implied by the model (based on rate differentials). Historically, the two metrics have followed each other. From May 2024 to early July 2024, there was a break from historical trends as there was a growing divergence between the USDJPY exchange rate vs model implied level. USDJPY exchange rate increased from 152 in May 2024 to a peak of 161 as of July 10, 2024, above the model implied level which fell from 153 to 148 during the same period. This suggests that USDJPY overshot fundamentals implied by interest rate differentials, but the recent moves have wiped out the “carry trade premium” and brought levels more in-line with fundamentals. USDJPY fell from 161 as of July 10, 2024 to 144 as of August 6, 2024 closing the gap premium, and is now trading closely to its fair value of 142 as of August 6. 2024.
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. Unless the U.S. macro outlook deteriorates meaningfully (which we are not expecting), we are unlikely to see further bouts of extreme yen strength.

JPY STILL LOOKS UNDERVALUED OVER A LONGER TIME HORIZON

USDJPY vs USD-JGB 10-year interest rate differentials, %

Source: J.P. Morgan Private Bank, Bloomberg Finance L.P. Data as of August 7, 2024. Today refers to August 7, 2024. 
The scatter-plot displays the correlation between the 10-year UST-JGB spread (difference in interest rates between 10-year US Treasury bonds and 10-year Japanese Government Bonds) and the USDJPY exchange rate. Each dot on the chart represents a data point, indicating the values of both variables at a specific time. The dots generally form a pattern that slopes upward from left to right, suggesting a positive correlation between the two variables. The means that as the 10-year UST-JGB spread widens (higher US interest rates relative to Japanese rates), then USDJPY exchange rate tends to rise which represents a stronger US dollar against the yen. The orange dot on the chart titled “Today” represents the 10-year UST-JGB spread and USDJPY on August 7, 2024, 10-year UST-JGB spread and USDJPY was 3% and 146.67 respectively. Dots above the dotted line suggests that JPY is undervalued while dots below the dotted line suggests that JPY is overvalued. As of August 7, 2024, JPY still looks undervalued over a longer time horizon.

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 increases downside risks to the outlook, we view the recent 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 increase exposure at those levels. 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).

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.

MARKETS HAVE PRICED OUT ANY SUBSTANTIAL RATE INCREASES FROM THE BOJ THIS YEAR AFTER THE SELLOFF

Implied policy rate based on OIS futures, %

Source: Bloomberg Finance L.P. Data as of August 7, 2024. OIS = Overnight Indexed Swaps.
The chart plots the implied policy rate based on Overnight Indexed Swaps (OIS) from August 2024 to June 2025. The grey line represents the implied policy rates as of August 2, 2024 while the blue line represents the implied policy rates as of August 7, 2024. As of August 2, 2024, implied policy rates were expected to increase from 0.227% in August 7, 2024 to 0.33% in December 2024. However, markets have priced out any substantial rate increases from the Bank of Japan this year after the recent sell-off. As of August 7, 2024, implied policy rates are expected to increase at a more gradual pace from 0.227% in August 7, 2024 to 0.294% in December 2024.
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.

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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.

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Morgan SE Brussels Branch is also supervised by the National Bank of Belgium (NBB) and the Financial Services and Markets Authority (FSMA) in Belgium; registered with the NBB under registration number 0715.622.844. In Greece, this material is distributed by J.P. Morgan SE – Athens Branch, with its registered office at 3 Haritos Street, Athens, 10675, Greece, authorized by the Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin) and jointly supervised by the BaFin, the German Central Bank (Deutsche Bundesbank) and the European Central Bank (ECB); J.P. Morgan SE – Athens Branch is also supervised by Bank of Greece; registered with Bank of Greece as a branch of J.P. Morgan SE under code 124; Athens Chamber of Commerce Registered Number 158683760001; VAT Number 99676577. In France, this material is distributed by J.P. Morgan SE – Paris Branch, with its registered office at 14, Place Vendome 75001 Paris, France, authorized by the Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin) and jointly supervised by the BaFin, the German Central Bank (Deutsche Bundesbank) and the European Central Bank (ECB) under code 842 422 972; J.P. Morgan SE – Paris Branch is also supervised by the French banking authorities the Autorité de Contrôle Prudentiel et de Résolution (ACPR) and the Autorité des Marchés Financiers (AMF). In Switzerland, this material is distributed by J.P. Morgan (Suisse) SA, with registered address at rue du Rhône, 35, 1204, Geneva, Switzerland, which is authorised and supervised by the Swiss Financial Market Supervisory Authority (FINMA) as a bank and a securities dealer in Switzerland.

In Hong Kong, this material is distributed by JPMCB, Hong Kong branch. JPMCB, Hong Kong branch is regulated by the Hong Kong Monetary Authority and the Securities and Futures Commission of Hong Kong. In Hong Kong, we will cease to use your personal data for our marketing purposes without charge if you so request. In Singapore, this material is distributed by JPMCB, Singapore branch. JPMCB, Singapore branch is regulated by the Monetary Authority of Singapore. Dealing and advisory services and discretionary investment management services are provided to you by JPMCB, Hong Kong/Singapore branch (as notified to you). Banking and custody services are provided to you by JPMCB Singapore Branch. The contents of this document have not been reviewed by any regulatory authority in Hong Kong, Singapore or any other jurisdictions. You are advised to exercise caution in relation to this document. If you are in any doubt about any of the contents of this document, you should obtain independent professional advice. For materials which constitute product advertisement under the Securities and Futures Act and the Financial Advisers Act, this advertisement has not been reviewed by the Monetary Authority of Singapore. JPMorgan Chase Bank, N.A., a national banking association chartered under the laws of the United States, and as a body corporate, its shareholder’s liability is limited.

With respect to countries in Latin America, the distribution of this material may be restricted in certain jurisdictions. We may offer and/or sell to you securities or other financial instruments which may not be registered under, and are not the subject of a public offering under, the securities or other financial regulatory laws of your home country. Such securities or instruments are offered and/or sold to you on a private basis only. Any communication by us to you regarding such securities or instruments, including without limitation the delivery of a prospectus, term sheet or other offering document, is not intended by us as an offer to sell or a solicitation of an offer to buy any securities or instruments in any jurisdiction in which such an offer or a solicitation is unlawful. Furthermore, such securities or instruments may be subject to certain regulatory and/or contractual restrictions on subsequent transfer by you, and you are solely responsible for ascertaining and complying with such restrictions. To the extent this content makes reference to a fund, the Fund may not be publicly offered in any Latin American country, without previous registration of such fund´s securities in compliance with the laws of the corresponding jurisdiction.

References to “J.P. Morgan” are to JPM, its subsidiaries and affiliates worldwide. “J.P. Morgan Private Bank” is the brand name for the private banking business conducted by JPM. This material is intended for your personal use and should not be circulated to or used by any other person, or duplicated for non-personal use, without our permission. If you have any questions or no longer wish to receive these communications, please contact your J.P. Morgan team.

JPMorgan Chase Bank, N.A. (JPMCBNA) (ABN 43 074 112 011/AFS Licence No: 238367) is regulated by the Australian Securities and Investment Commission and the Australian Prudential Regulation Authority. Material provided by JPMCBNA in Australia is to “wholesale clients” only. For the purposes of this paragraph the term “wholesale client” has the meaning given in section 761G of the Corporations Act 2001 (Cth). Please inform us if you are not a Wholesale Client now or if you cease to be a Wholesale Client at any time in the future.

JPMS is a registered foreign company (overseas) (ARBN 109293610) incorporated in Delaware, U.S.A. Under Australian financial services licensing requirements, carrying on a financial services business in Australia requires a financial service provider, such as J.P. Morgan Securities LLC (JPMS), to hold an Australian Financial Services Licence (AFSL), unless an exemption applies. JPMS is exempt from the requirement to hold an AFSL under the Corporations Act 2001 (Cth) (Act) in respect of financial services it provides to you, and is regulated by the SEC, FINRA and CFTC under US laws, which differ from Australian laws. Material provided by JPMS in Australia is to “wholesale clients” only. The information provided in this material is not intended to be, and must not be, distributed or passed on, directly or indirectly, to any other class of persons in Australia. For the purposes of this paragraph the term “wholesale client” has the meaning given in section 761G of the Act. Please inform us immediately if you are not a Wholesale Client now or if you cease to be a Wholesale Client at any time in the future.

This material has not been prepared specifically for Australian investors. It:

  • may contain references to dollar amounts which are not Australian dollars;
  • may contain financial information which is not prepared in accordance with Australian law or practices;
  • may not address risks associated with investment in foreign currency denominated investments; and
  • does not address Australian tax issues.

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JPMorgan Chase Bank, N.A. and its affiliates (collectively "JPMCB") offer investment products, which may include bank-managed accounts and custody, as part of its trust and fiduciary services. Other investment products and services, such as brokerage and advisory accounts, are offered through J.P. Morgan Securities LLC ("JPMS"), a member of FINRA and SIPC. Insurance products are made available through Chase Insurance Agency, Inc. (CIA), a licensed insurance agency, doing business as Chase Insurance Agency Services, Inc. in Florida. JPMCB, JPMS and CIA are affiliated companies under the common control of JPMorgan Chase & Co. Products not available in all states.

 

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INVESTMENT AND INSURANCE PRODUCTS ARE: • NOT FDIC INSURED • NOT INSURED BY ANY FEDERAL GOVERNMENT AGENCY • NOT A DEPOSIT OR OTHER OBLIGATION OF, OR GUARANTEED BY, JPMORGAN CHASE BANK, N.A. OR ANY OF ITS AFFILIATES • SUBJECT TO INVESTMENT RISKS, INCLUDING POSSIBLE LOSS OF THE PRINCIPAL AMOUNT INVESTED

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