Why investors must think about the yen when they look at Japanese markets

“Japan’s Nikkei 225 index is finally grabbing some headlines – and attention from investors – as it finally exceeds 1989’s peak and motors on to new highs, but anyone wishing to allocate money to the Tokyo market must keep an eye on the yen,” says AJ Bell investment director Russ Mould.

“In sterling terms, the Nikkei trades a fraction below the peak it set three years ago and that is because the Japanese currency has slumped by nearly a quarter over that period, from ¥147 to the pound to an eight-and-a-half year low of ¥190.

“A gain of precisely nothing in pounds will be a grave disappointment to those who have ridden the Nikkei up for the last three years and may give would-be buyers pause for thought.

Source: LSEG Datastream data

“Japan does seem to have a lot going for it:

• It has underperformed other global markets horribly for a long term. Underperformed means unloved and unloved can mean undervalued.
• Many Japanese firms are chock-full of cash, after taking on the lessons learned when the Tokyo market’s debt-fuelled bubble burst in 1989. It is now the West that is awash with corporate (and sovereign and consumer) debt.
• Thanks to the reforms launched by the late, lamented Shinzo Abe during his second term as prime minister, Japanese firms are now much more focused on good corporate governance and shareholder returns (a trend which is catching the eye of overseas activist investors and also stoking a fresh round of merger and acquisition activity).
• With its heavy weightings toward information technology (26%) and industrials (17%), the Nikkei 225 also taps into the key themes of artificial intelligence and deglobalisation, as Japanese firms may be primed to benefit from sanctions against China, as a valuable alternative source. A low weighting toward financials (3%) is also noteworthy, as banking stocks in the USA and UK continue to flounder.
• Finally, the Bank of Japan remains committed to ultra-loose monetary policy, in contrast to those in the West. While the US Federal Reserve, European Central Bank and Bank of England have jacked up interest rates and started to shrink their balance sheets, the Bank of Japan has stuck with a negative interest rate since 2016 and continued to run a Qualitative and Quantitative Easing (QQE) bond buying scheme, designed to suppress bond yields and borrowing costs and pump liquidity into Japan’s economy and financial system.

Source: LSEG Datastream data, Bank of Japan, FRED - St. Louis Federal Reserve database

Source: LSEG Datastream data, Bank of Japan, FRED - St. Louis Federal Reserve database

“That monetary largesse does come with a cost, however, because the yen continues to slide. The yen is back down to ¥150 to the dollar, pretty much an all-time low, and ¥190, a level last seen in autumn 2015.

“The plunge in the yen may be a boon for exporters, including the technology and industrial companies in which Japan specialises, but it also robs overseas investors of some of their gains in the value of Japanese assets, such as the Nikkei 225 stock market index.

Source: LSEG Datastream

“Anyone looking to put money into Japan must think about the currency and therefore the Bank of Japan’s monetary policy. The BoJ is, in theory, laying the groundwork for a retreat from QQE and its first interest rate increase since February 2007, now that inflation exceeds its 2% target.

“If Japan starts tightening policy just as the US Federal Reserve and Bank of England start to loosen it again, via rate cuts, then the yen could advance. What that could do to the Tokyo stock market and all of its prized exporters remains to be seen, although QQE would presumably only be withdrawn very gradually, just as the Fed and Bank of England have reduced the size of their asset holdings in baby steps.

“But interest rate differentials are just one reason behind the yen’s weakness. Another possible contributor is how international investors (and particularly hedge funds) use the yen as a funding currency for other positions. It costs nothing to short the yen, given the negative interest rate that prevails in Japan, and that cheap cash can be used to generate returns elsewhere (or so the theory goes). Data from America’s Commodity Futures Trading Commission (CFTC) shows that short positions are again piling up against the yen.

Source: US Commodity Futures Trading Commission, LSEG Datastream data

“It may therefore not be entirely a coincidence that global equities are surging along, buoyed by the USA, which represents some 60% of the FTSE All-World index. Other factors are helping here, too, notably Bidenomics and free-spending fiscal policy, but a plentiful supply of cheap funding might also be helping.

Source: LSEG Datastream data

“Investors the world over may therefore need to keep an eye on the yen, and not those who are warming to Japan as it emerges from a thirty-four-year funk. If the Bank of Japan does tighten policy, just as western central banks lay the groundwork for their first cuts, a reduced interest rate differential could spark buying of the yen, prompt a closure of short positions against it and turn off the tap on one important source of global liquidity.”

These articles are for information purposes only and are not a personal recommendation or advice.