This article was taken from the August 2024 issue of Market Insight. To subscribe to our investment publications, please visit www.redmayne.co.uk/publications.
The start of August saw a turbulent time for Japanese equities. On Monday 5
th of August investors saw the benchmark index Nikkei 225 fall by a record 12.4% from close on the previous Friday, an even steeper drop to the one seen on Black Monday in 1987. Trading on the Osaka Stock Exchange was temporarily halted in a bid to restore calm after a flurry of sell orders were placed. However, on the following day the market had regained over 10%. Japan was not alone in this sudden volatility; the selloff was global and partly prompted by weaker than expected US employment data, but the Japanese market suffered a larger drop than many others. This raises the question of why the labour market in Ohio or Texas should have such a large impact on a stock market across the Pacific? Let’s examine the background of this unique market and the factors involved in its plunge and subsequent recovery.
To understand where we are now, we have to look back over 30 years to the end of the 1980s. The stock market had seen huge growth over the decade, with Japanese equities representing an incredible 45% of the global stock market. The boom extended to real estate, with Tokyo’s fashionable Ginza district valued at US$230,000 per square meter. On 29 December 1989, the Nikkei hit an all-time high. The nation had never felt so confident and prosperous, but the economic boom was about to come to an abrupt end. Within the space of a year, the stock market lost more than US$2tn in value. Real estate and the Japanese Yen followed. A lost decade ensued and the economy never quite found its footing. The Japanese economy has had to contend with persistent low growth and a weak currency ever since.
In the years that have followed, attempts have been made to boost Japan’s lacklustre economy. Shinzo Abe, the Japanese Prime Minister between 2006-2007 and 2012-2020, introduced a raft of monetary and fiscal reforms during his tenure. Taking the form of “three arrows”, these consisted of a substantial stimulus package, quantitative easing and structural reforms aimed at businesses and the labour market. This approach came to be known as ‘Abenomics’ and has been upheld by his successor Fumio Kishida. However, growth, inflation and interest rates have all been slow to recover since the 1989 asset bubble collapse.
The Japanese Yen has had a particularly turbulent period in recent years. As part of Abe’s reforms, the Bank of Japan kept interest rates very low in a bid to increase inflation, bank lending and overall demand. As other central banks worldwide have raised interest rates to combat the sharp rise in inflation which began in 2021, the Bank of Japan bucked this trend and maintained interest rates under zero until March of this year. This has seen a substantially weaker Yen, losing more than a third of its value since the beginning of 2021 until the interest rate increase. In April this year, the Yen reached a low that has not been seen since 1990. The impact of a weaker currency within Japan has been mixed. Increased import costs on energy and food in particular have squeezed household budgets, while Japanese exports have benefitted. The weak Yen has also fuelled a tourism boom, as visitors discover the very favourable exchange rate. A record 17.8mn foreign tourists arrived in the first six months of the year.
Conversely, as the Yen has struggled, the Nikkei 225 climbed to a new all-time high earlier this year, reaching a level not seen since the boom years of the 1980s. There are several headwinds behind this recent resurgence in the Japanese market. Partly this has been caused by the weakening of the Yen whereby Japanese equities appear cheap to overseas investors. Overseas buyers have also found the market an attractive alternative to China when looking for Asia Pacific exposure, investing US$24bn into the equity market in 2023. Corporate reforms have also played their part in reigniting interest in this long-neglected market. The Tokyo Stock Exchange has been pushing companies with underperforming shares to make better use of their capital and improve fundamentals to make them more appealing to investors. This has led to record buybacks and the unwinding of unproductive cross-shareholdings. The exchange has also called on companies to disclose their plans for improving capital efficiency, and has published a list of those who have complied with this request. Japanese companies and households alike have substantial cash savings, in the quadrillions of Yen, which if invested would see substantial market growth.
2024 has found a Japanese economy somewhat at odds with itself; a struggling currency and a resurgent stock market. In early August, the Bank of Japan raised interest rates for a second time in 2024 and the market has speculated that further raises may be on the horizon. Japan’s bid to increase inflation has worked, but perhaps too well. The exchange has also called on companies to disclose their plans for improving capital efficiency, and has published a list of those who have complied outpaced earnings and the bank is concerned about the impact on consumers. At the same time, in the US the Federal Reserve has indicated that a rate cut may be imminent, alongside lower than expected employment figures, the lower employment numbers would suggest a rate cut is more likely. This narrowing interest rate gap has seen the Yen strengthen recently, at one point reaching a seven-month high. This divergence is significant and goes some way to explain why the subsequent market fall was so steep. A ‘carry trade’ is where investors borrow from a market with low interest rates (such as Japan) and invest it in a currency with a higher interest rate, capturing the difference between the rates. In this case, a stronger Yen means the loan will be harder to pay back, potentially wiping out any gains. As the Yen rapidly rose, traders were compelled to exit their positions. Negative sentiment spread, and markets bore the brunt. The panic was short-lived however, stocks swiftly recovered and stability was resumed.
If there is a lesson to be learned from this, perhaps it is a reminder that short-term movements, however dramatic, shouldn’t dictate an investment strategy. Investing is a long game, and for Japanese equities it has been a very long game. The Bank of Japan will have to balance the need for growth, while keeping inflation at a tolerable level and boosting the strength of the Yen. The challenge is complex and many-faceted, but with the equity market seeing a recovery, there may be cause for optimism.
Please note that this communication is for information only and does not constitute a recommendation to buy or sell the investments mentioned. Investments and income arising from them can fall as well as rise in value. The information and views were correct at time of publication but may have changed at point of reading.