Despite near-term vulnerabilities, structural supports remain in place.

The Nikkei 225 rallied more than 60% between January 2023 and July 2024 (Chart 1), rising above pre-1990-crash peaks due to several factors.

These included improved governance of Japanese corporations, which focused more on shareholder returns; a weak yen, which helped to boost reported corporate earnings as international revenue was flattered by a currency translation effect; and optimism that the economy was finally exiting thirty years of deflation or disinflation, which helped boost expectations about future earnings.

However, in late July and early August the rally lost steam. The index was hit by a perfect storm of a surprisingly hawkish Bank of Japan (BoJ) policy statement, increased concerns of a US recession, stretched short positions on the Japanese yen, and holiday-driven thin market liquidity.

As short positions were flushed out, the yen returned to trade in line with 10-year swap rate differentials (Chart 2).

Further carry trade unwind could cause volatility

While the global spillovers from the carry trade unwind eased over the course of August (Chart 3), the outstanding yen carry trade remains significant.

Admittedly, the range of estimates is extensive because foreign exchange positions are not tracked centrally on exchanges. However, proxies such as Japanese banks’ foreign lending suggest that a $1 trillion carry trade is still in place. Estimates from Japan’s net international investment position point to a $3½ trillion carry trade, but this includes foreign reserves.

While a further unwind could trigger fresh market volatility, the BoJ does appear to be somewhat chastened by the experience and is treading more carefully in its gradual tightening cycle. Meanwhile, the fundamental case for Japanese equities remains in place.

Corporates prepared for modest yen strength

Japan is home to many global exporters, with some large corporates dominating the Nikkei and TOPIX, deriving a significant portion of their revenues from overseas.

Therefore, sectors that benefit from yen weakness underperformed following the yen's rapid appreciation in August. These include trading companies, machinery exporters, autos, metal products, and mining. Banks and insurers were also hit hard despite expectations for higher rates, which might usually be expected to help banks.

Meanwhile, real estate as captured by the TSE REIT Index has performed well in dollar terms, as have small caps and growth stocks.¹ Some companies may have to cut guidance if the yen rallies significantly further from here. That said, a Nikkei survey of 380 companies as of 15 May showed that most Japanese companies assume a USDJPY range of 140-150. This was stronger than the approximately 155 exchange rate at that point. By conditioning forecasts and analyst expectations on the basis of a stronger yen, corporates hope to avoid having to deliver unpleasant earnings surprises.

Crucially, though, it is not so much the exchange rate itself that matters for corporates as the stability of the currency. When the yen depreciated earlier this year, business surveys cited exchange rate volatility as a constraint to long-term planning and investment. Volatility in input costs is often absorbed into margins rather than passed on to price-sensitive households.

As a result, the BoJ, which previously thought little of surprising markets, is likely to tread more carefully to avoid a repeat of the August volatility. Nonetheless, as the BoJ slowly tightens and the Fed eases policy, further bouts of yen volatility could trigger short-term turbulence in Japanese equities.

The economic backdrop may become more supportive

The “deflation mindset” that plagued the Japanese economy for the last thirty years meant that households were reluctant to accept price increases, limiting corporate pricing power. When input costs rose sharply during and after the pandemic, corporates were unable to pass these on and faced margin erosion.

While we think the jury is still out on whether Japan has permanently exited its low inflation regime, recent developments certainly look supportive of Japanese equities.

A sustainable shift to a new inflation regime requires positive real wage growth that supports consumption. That is why it is so important that the strong Shuntō wage negotiations of last spring are finally feeding through to realized earnings.² Base pay has started to increase (Chart 4), and real wage growth is finally positive.

If this trend continues, consumer spending could gather pace and become resilient to corporates passing on input cost growth.

However, Japan still has a persistent negative output gap, which limits the scope for domestically generated core inflation pressures to take hold. The BoJ is set to tighten policy very gradually, with interest rates rising only modestly over the next few years.

This combination of still low interest rates, real wage growth supporting domestic consumption, and more pricing power for corporates may provide a supportive backdrop for equities over the medium term.

Corporate reforms have further to run

Japan’s push for improved corporate governance is still in its early stages.

The Tokyo Stock Exchange (TSE) began promoting reforms aimed at increasing shareholder value by placing pressure on companies to improve return on equity, increase dividend payouts, and buy back shares.³ Moreover, the TSE and domestic activist investors demanded that companies explain low valuations.

Efforts to enhance corporate transparency and efficiency included reducing cross-shareholding, a practice long criticized for inefficient capital use and poor corporate governance.

While many of the easy wins have been achieved, there is still more progress to come. TSE disclosures are not binding but have been firmly embraced by large firms, boosting foreign investor interest. Domestic scrutiny should continue to improve governance through peer pressure, spreading more broadly across smaller firms over time.

An integral position within the global value chain

Japan plays a critical role within the global value chain. It is a major producer of advanced manufacturing, robotics, auto components, and semiconductors.

Future trends in artificial intelligence (AI), as well as reshoring and friendshoring, are likely beneficial. For example, a leading producer of cutting-edge semiconductors in Taiwan has plans to build additional fabs in Japan. And while Europe remains a heavy producer of internal combustion engines (ICEs) and has fallen behind China in electric vehicle (EV) production, Japan has taken a more nuanced approach.

By using hybrids to bridge the gap with EV technology, Japanese manufacturers are just as, if not more, profitable than some EV firms. Inventories of hybrids are low, averaging 25 days compared to ICE vehicles that can take up to two months to clear.

This hybrid story is unique to Japan, differentiating it from other auto producers.

Japan should be able to navigate geopolitical shocks

Following the US election, Japan may be a particular target of any additional tariff and trade restrictions.

The first Trump presidency had a complex impact on the Japanese economy. The autos sector was initially targeted for US tariffs. Still, the two countries later entered a bilateral trade agreement to lower tariffs on US agricultural products in exchange for avoiding tariffs on Japanese autos. Meanwhile, Japan had viewed the Trans-Pacific Partnership to strengthen economic ties with the US and the other signatories.⁴

The US withdrawal from the agreement led to increased efforts by Japan to revive the deal as the Comprehensive and Progressive Agreement for Trans-Pacific Partnership (CPTPP) and bolster the regional trade framework without the US.⁵

More generally, US-Japan relations under the first Trump presidency were carefully managed. Officials managed to strike numerous bilateral agreements, compromises, and exemptions.

The Biden administration maintained many of the Trump administration's trade restrictions and tariffs. Most recently, the Foreign Direct Product Rule (FDPR) was expanded to target Chinese semiconductor companies.⁶

Access is limited to advanced chips, equipment, and technology of US origin or produced using US-based technology. Exemptions were made for allies, including Japan. Despite this, media reports in July that the Biden administration could expand restrictions to control exports of products that use any US technology led to a sell-off in semiconductor stocks.

These new measures could restrict Japanese sales, servicing and repairs of advanced semiconductor equipment to Chinese customers. In turn, China could retaliate and limit Japan’s access to minerals that are essential for auto production.

Officials are in talks to ensure exemptions and safeguard access to critical minerals. Experience suggests that Japan may be well-positioned to navigate headwinds from trade barriers, given its relative nimbleness in the geopolitical stage.

Domestic politics is unlikely to impact the longer-term outlook for equities

The ruling LDP-led coalition lost its majority in the lower house election on 27 October. We outlined the policy implications of different coalition partnership scenarios here.

An expanded governing coalition with a like-minded third party or supply-and-confidence arrangements should not lead to major policy reversals. However, fiscal policy is widely expected to be looser.

Equities started to sell off before the election as polls signaled the coalition would lose its majority. The Nikkei 225 rallied 1.8% in response to the election result, recovering some of the prior week’s losses.

The yen has been steadily depreciating over the past month, which is in line with US-Japan swap rate differentials. This raises the risk of carry-trade-related volatility. However, foreign short positioning is not as stretched as it was ahead of the summer turbulence. Given the additional uncertainties around the US election and the BoJ policy path, Japanese equities are likely to remain within a volatile range for much of Q4. However, the longer-term structural drivers outlined here remain in place.

There is still a case for Japanese equities

It is essential to distinguish between near-term risks and longer-term opportunities. A stronger yen over the coming months could favor domestic corporates. Attractive opportunities might arise in small- and mid-caps, and also in more domestic-oriented stocks.

Defensives, healthcare, and staples have done well despite concerns about the US slowdown and yen appreciation. However, playing Japan’s aging demographic theme is not profitable, given declining tax receipts and fiscal constraints.

Themes such as innovation in healthcare provide more fundamental opportunities. Medical technology or pharmaceuticals are more defensive sectors less sensitive to currency volatility and could outperform in this current environment.

¹ The TSE REIT Index is a capitalization-weighted index based on all real estate investment trusts (REITs) listed on the Tokyo Stock Exchange. It indicates current level of market capitalization compared to the base point (1,000 pts) on the base date (March 2003).
² Shuntō is a Japanese term, usually translated as "spring wage offensive." It refers to the annual wage negotiations between enterprise unions and the employers in Japan.
³ The Tokyo Stock Exchange (TSE) is the largest stock exchange in Japan, headquartered in its capital city of Tokyo.
⁴ The Trans-Pacific Partnership (TPP) was a proposed trade agreement among 12 Pacific Rim economies, including Australia, Canada, Japan, the United States, and others12. However, the TPP was not fully implemented.
⁵ The Comprehensive and Progressive Agreement for Trans-Pacific Partnership (CPTPP), often abbreviated as TPP11 or TPP-11, is a trade agreement between Australia, Brunei, Canada, Chile, Japan, Malaysia, Mexico, New Zealand, Peru, Singapore, and Vietnam.
⁶ "Explainer: What is 'FDPR' and why is the U.S. using it to cripple China's tech sector?" Reuters, October 2022. https://www.reuters.com/technology/what-is-fdpr-why-is-us-using-it-cripple-chinas-tech-sector-2022-10-07/.

Important information

Projections are offered as opinion and are not reflective of potential performance. Projections are not guaranteed and actual events or results may differ materially.

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