That Japan unexpectedly slipped into recession will make the market care. Profits of listed companies are soaring, and share prices are peaking. Investors say there is much more in store, but the yen must continue to cooperate.
Goldman Sachs already refers to the «Seven Samurai» in its notes to clients, alluding to the classic Akira Kurosawa film, later remade in the US as «The Magnificent Seven.»
The share price gains of the Seven Samurai - Screen Holdings, Advantest, Disco, Tokyo Electron, Toyota Motor, Subaru, and Mitsubishi Corp - are based on rapidly rising profits and spiking buyback levels and dividend payouts. While the Nikkei 225 broke through a 34-year high last Thursday, half of Japanese companies are still trading below their book value.
Investors are therefore lyrical, but further upside depends largely on the yen, which is the weakest currency in the G10 this year due to the large interest rate differential between Japan and the West. The currency lost more than 9 per cent against the dollar over the past 12 months, a decline that celebrated its third anniversary last month. A weak yen has historically been good for the stock market, where key stocks such as Subaru (plus 25 per cent year-to-date (ytd)) and Toyota Motor (plus 30 per cent ytd) generate much of their sales outside Japan.
Pressure on yen expected to remain
The unexpected recession, announced last week at the same time as the new peak, is also grist to the mill of foreign investors. They currently account for 70 per cent of trading on the also-peaking Topix, the country’s broadest stock index. The market expects that the economic setback will prevent the Bank of Japan (BoJ) from implementing significant interest rate hikes in the near term, despite the unique inflation level of 2 per cent. As long as the interest rate differential with the West does not close, pressure on the yen is expected to remain high.
«Bad news is good news and vice versa. In this case, that means that the monetary exit playbook moves to the deep freeze for a while, where it has been lingering for a long time,» said Christofer Govaerts, chief strategist at Bank Nagelmackers in Belgium. «This explains why the export-sensitive Japanese stock market expressed in yen has been yawning recently.»
According to data from the Japan Exchange Group, domestic buyers largely remain on the sidelines, while Japanese institutional investors are shrinking their portfolios. Retail investors are flocking to the US and other foreign markets, Bloomberg data show.
Both investors and the central bank consider it likely that the BoJ will stop its negative interest rate policy (currently minus 0.1 per cent) this spring after all. Makoto Sakurai, a former BoJ board member who has close ties with incumbent policymakers, according to the Japanese newspaper Asahi, argues that the end of negative interest rates is «unlikely to hurt the economy much.»
The bank will proceed very gradually, allowing short-term interest rates to rise to around 0.5 per cent over the course of several years, Sakurai told reporters at Asahi. Long-term interest rates are also expected to rise to about 1.5 per cent to 2.0 per cent in three to four years. Currently, the market rate on a 10-year government bond is 0.7 per cent.
According to Christopher Dembik, chief strategist at Pictet AM, the «very moderate pace» will have little impact on the yen. «The yen’s weakness will persist for most of the year, benefiting foreign investors in the Nikkei 225,» Dembik said.
Should the currency be hedged?
If the yen unexpectedly does strengthen quite a bit due to higher interest rates, one of the things investors will be encouraged to do is unwind so-called carry trades, borrowing money to invest in higher-yielding currencies. That could trigger a return of Japanese capital to domestic bond markets, a move that could fuel market volatility.
«Higher interest rates and a more expensive yen will punish profits and slow the process of rising inflation. That will be able to put pressure on valuations,» said Erik Mijot, head of global equity strategy at Amundi Investment Institute. «So for international equity investors, it could be attractive not to hedge the yen in 2024.» This seems counterintuitive, as in past decades it was obvious to go short in the currency if you wanted to go long in equities.
However, according to Arnout van Rijn, portfolio manager at Robeco, corporate profitability has become much less dependent on international trade than people think. «Many companies have learned to hedge against the vagaries of the forex market,» said Van Rijn. His team also made the unusual move this month to go long on both the currency and equity markets at the same time.
Robeco is positive on the Japanese equity market, but at the same time «vigilant about the tail risk of the world’s largest monetary experiment, with «tight stop-loss levels,» Van Rijn said.