What’s happening in Japan?

Key Points

• The Nikkei 225 fell dramatically in early August (down 17%)¹ amid rate increases by the Bank of Japan (BOJ) that changed the market’s view of the Japanese economy. For context, the Nikkei is now down 2% over one year, but up over 20% in total over the past three years and 67% over five years.²

• The size and rapidity of the sell-off combined with a rising Yen indicates this was a partial unwinding of the yen carry-trade – where large investors borrow in the low-cost Yen to buy higher-yielding assets like US Treasuries. Higher Japanese rates upend this trade and the market action over the past few days points to automated trading strategies rushing to the exits.

• Platinum’s longer-term fundamental view on Japan remains unchanged. The corporate governance reforms implemented over the past decade should continue to improve shareholder returns. Japanese companies have sound balance sheets and the country – and its corporates - are investing heavily in digitisation aimed at enhancing productivity.

How a hawkish turn by the BOJ backfired

Following the July 31st monetary policy meeting, the BoJ announced they would raise their benchmark policy interest rate from 0~0.1% to 0.25%. They also announced a scaling back of monthly JGB purchases to ¥3tr by 2026 - roughly half the current level.

While both moves were anticipated as part of Japan’s slow move back towards “normal” interest rate settings, the suggestion from Governor Ueda that further hikes were in prospect rattled a market used to dovish commentary from Japanese policy makers. In just a few days, the market has gone from expecting slow normalisation to pricing in a more aggressive tightening cycle in Japan.

At the same time, weaker than expected jobs data in the US last week pointed to a new risk of an economic slowdown in the world’s largest economy. In contrast to Japan, market are now pricing in an easing cycle in the US.

The carry trade and falling markets

The confluence of these two policy narratives last week appears to have triggered an unwind of the Yen/Dollar “carry trade”.  

The carry trade is a trading strategy where investors borrow cheap Japanese Yen and then invest in higher yielding overseas assets such as US Treasuries. It has worked for many years but it’s predicated upon Central Banks acting predictably – and on limited volatility in currency markets.

With the BOJ using ultra-easy monetary policy to support their economy - and the Fed pushing rates up to deal with sticky inflation - this “trade” was lucrative.

Take out one leg of this trade (or both in this case), and there’s a rush to unwind. In modern markets, automated systematic strategies that employ trading algorithms often magnify these moves in a short period of time as stop losses are triggered. What we’ve seen in the past couple of days is an outsized reaction to a minor underlying catalyst.

The Yen – tailwind and headwind

Japan’s stock market is quite sensitive to currency movements, reflecting the importance of global markets for larger Japanese companies. As the Yen has weakened over the past two years this has been a significant earnings tailwind to Japan’s blue chips such as Sony and Toyota. As this reverses, the currency becomes a headwind to earnings growth.

The Platinum view

The Japanese domestic economy, while strengthening, remains fragile, so it's possible hawkish BOJ commentary may be tempered should economic data clearly soften. Indeed the Japanese Government Bond market has rallied strongly following the BOJ decision, implying that the bond market is now concerned about an economic slowdown. If this eventuates, the need for further interest rate hikes is diminished.

We think the market has overreacted in the short term. We remain upbeat about the long-term prospects for the Japanese sharemarket.

• Corporate governance reforms are accelerating, laying the foundation for better returns on capital and higher shareholder returns.
• Japanese corporate balance sheets remain strong, with ample cash reserves.
• Earnings forecasts by Japanese corporates generally adopt a conservative view of the currency (e.g. Toyota assumes a FY25 USDJPY rate of 145).
• We see a multi-year capex cycle rolling out in Japan as corporates move to reshore value chains and modernise Japan’s ageing manufacturing. Faced with a declining workforce, Japan is investing in their digital capabilities, intent on raising productivity.

For context, following the sharp selloff, the Nikkei’s price to earnings ratio has fallen to around 14X. That’s below its 20 year average of 15.5X, and returning to levels that in the past have been associated with economic distress such as the GFC and the pre-Abenomics period. In short, the Japanese market now appears cheap.

Short term volatility may capture headlines but the longer term direction of the fundamentals in Japan remain very encouraging.