Japan: Time for a trade?

Japan ranks among the exotic birds among the world’s equity markets. Given the Japanese stock market’s mostly disappointing performance in recent years (and decades), investors were well advised to minimize their exposure to the land of the rising sun. But now, a monetary policy pivot by the Bank of Japan and a strengthening of the yen may open a rare tactical window of opportunity in the months ahead.

Strong performance, but only in yen

Japanese stocks ranked among the frontrunners last year (alongside UK equities). But like so much on the financial markets, this is a relative observation because it is viewed through the lens of the Japanese yen. From the perspective of an investor with the US dollar as his or her reference currency, the return on an investment in Japan in 2022 actually underperformed the return on European or Swiss stocks and only marginally outperformed the weak US market. That was no anomaly. In fact, in recent years and decades, a bet on Japan was really a bet on a weak yen. Investors who hedged the currency risk were the only ones who were truly able to profit from the temporary rallies on the Japanese equity market. A textbook example of this was the Abenomics rally that began in late 2012. In the span of less than two-and-a-half years, the rally caused the Topix index to more than double (in the local currency), but for US investors, the value appreciation amounted to only half that, and investors with the euro or the Swiss franc as their reference currency didn’t fare much better. Should investors enter Japan now armed with currency hedges? After all, they would have ranked among the winners had they done so in 2022.

A question of which currency | The (weak) yen makes the difference

Performance of equity markets since 2022

Sources: Bloomberg, Kaiser Partner Privatbank

But it’s not quite as simple as that. During the era of zero to negative interest rates, the cost of hedging yen risk was almost free of charge, but today the hedging expense ranges from 1.6% (CHF) to 5% (USD) per annum. In the wake of the interest-rate turnaround by central banks, Japanese stocks are only interesting if a strong yen acts as an additional positive performance driver. A look at the past supports this assertion. Over the last 35 years, there were five episodes during which the yen appreciated by at least 20% against the US dollar. Averaging out all observations, the Topix outperformed the S&P 500 index by 16% during those phases, but with wide variances, mind you. There consistently was a robust outperformance (without currency hedging) whenever yen strength was accompanied by major political changes such as structural reforms and/or fiscal stimulus programs that attracted an influx of investment capital from abroad, such as during the periods from 1998 to 2000 (stimulus and recovery after the Asian crisis) and from 2002 to 2005 (structural reforms under then Prime Minister Koizumi).

Downward in the long term | Japan is a trading market

Topix vs. S&P 500 index (in USD) and Japanese yen appreciation phases

Sources: Bloomberg, Kaiser Partner Privatbank

The case for the Japan trade

Japan today may be poised to face another major upheaval in 2023, one that – strictly speaking – has already begun. The Bank of Japan is in the process of returning its monetary policy to normal and bidding farewell to controlling the yield curve. There are plenty of reasons for doing that. Not only does the BoJ’s still ultra-accommodative monetary policy stand in stark contrast to the policies being pursued by every other central bank, but it also glaringly clashes with the reality of Japanese inflation, which could lastingly become unstuck from the deflationary glue that has prevailed in recent years (and decades). Japan’s aging population and the country’s shortage of skilled labor and its restrictive immigration policy point to this happening. A permanent inflation comeback in Japan is no longer merely a vision, but a realistic scenario today. The recently disclosed surprisingly high wage hikes in the annual labor agreement negotiations in Japan buttress this expectation and will likely encourage new BoJ Governor Kazuo Ueda in the months ahead to continue or even accelerate the normalization process that was started under Haruhiko Kuroda. This brightens the prospects for many investors. It does so, on the one hand, for local investors, who have now finally resumed receiving interest on fixed-income investments in their homeland and no longer have to park their money outside Japan, and it does so, on the other hand, also for foreign investors, who get not just an inexpensively valued equity market in historical terms, but also one with a currency turbocharger attached to it to boot.

Relatively attractive | Japanese stocks are inexpensively valued in historical terms

Relative valuation of Topix index (price-to-earnings ratio)

Sources: Bloomberg, Kaiser Partner Privatbank

Alongside the reversal of net capital flows back into and no longer out of Japan, there are also additional arguments in favor of the Japan trade. In contrast to other markets, the correlation between bond yields and stock valuations in Japan has been positive in recent decades. This means that higher yields could foster an upward revaluation of Japanese stocks. After years of interest rates being at low tide, the rate reversal is bound to put a tailwind particularly behind banking stocks. Moreover, many Japanese companies in recent years have done their homework and have strengthened their balance sheets and enhanced their profitability on the back of capital discipline, efficiency gains and shareholder-friendly policies. Finally, a look at the technical chart signals also inspires optimism: last autumn, the Topix in US dollar terms ricocheted upward off its uptrend line in place since 2009. This theoretically clears the way for the index to make a potentially successful second run at its all-time high from 1989 (after the failed attempt in 2021). The Japanese yen has appreciated by around 10% against the US dollar since October 2022. On a dollar basis, the Topix has outperformed the S&P 500 index by a good 15% since then. The Japan trade has thus gotten off to a good start.

In an uptrend | Well supported by the technical chart signals

Topix index (in USD) and Japanese yen appreciation phases

Sources: Bloomberg, Kaiser Partner Privatbank