Will the Yen Continue to Support Japanese Equities?

No. The Japanese yen has been on a weakening trend for several years. For most of that time, it has been a lynchpin of Japanese equity outperformance in local currency terms. We believe there is limited further downside for the yen, which, while removing a headwind for USD returns, also removes the main pillar of earnings per share (EPS) outperformance. Therefore, we recommend holding Japanese equities at benchmark weights.

Over the last four years, the Japanese yen has consistently weakened, experiencing a 34% decline against the dollar since the end of 2020, and comparable depreciations against the euro, UK sterling, and Swiss franc. Currently, the yen’s real effective exchange rate is at its lowest since December 1971, standing at the 4th percentile of observations since 1970, with a 36% undervaluation compared to its historical median.

Widening interest rate differentials between Japan and its peers lie at the heart of this broad depreciation. The COVID-era inflation surge occurred earlier in other markets, which resulted in central banks raising rates aggressively in those regions. Meanwhile, the Bank of Japan (BOJ) maintained monetary policy at extremely accommodative settings for a prolonged period as a result of both a delayed exit from lockdowns and secularly low domestic growth. Indeed, they have only recently exited what may be termed ‘emergency settings’ by ending their explicit yield curve control policy and taking rates out of negative territory.

Japan’s first quarter GDP contraction of 0.5% suggests near-term policy tightening is unlikely. Nonetheless, with policy rates in peer regions at cyclical highs, and limited room for the BOJ to ease, a narrowing of interest rate differentials is the probable direction of travel. Most developed markets (DM) central banks are likely to reduce rates from their current restrictive stances and bring them back towards a more neutral level. When weak growth in certain regions is added to the equation, that potentially accelerates the timeline over which easing will occur. This process has already begun in Switzerland and Sweden and may kick off in the Eurozone and United Kingdom as soon as next month. The muted pricing in of cuts in the United States also points to the potential for a narrowing of rate differentials. What’s more, Japanese authorities have shown intent to intervene to strengthen the yen when it has approached 160 to the US dollar, a level that is approximately 2% away.

The weakening yen has provided a dual benefit to Japanese companies’ earnings. It has enhanced the competitiveness of exporters by making their goods and services more affordable internationally, and it has boosted earnings directly through the favourable translation of foreign revenues back into yen. This earnings backdrop has driven strong local currency outperformance. However, for non-Japanese investors, the impact of holding assets denominated in a depreciating currency has largely neutralised these local currency gains, resulting in a performance that is broadly flat when measured in US dollars. Hedging out yen currency risk has worked well in this environment, with local currency outperformance supplemented by positive carry from the hedge. While this can persist with a weakening or range-bound yen, such a position is exposed to a sharp strengthening of the currency. The EPS tailwind would become a headwind, without the benefit of the strengthening yen as an offset.

While we do not foresee Japanese equities continuing to benefit from a weakening yen, and relative valuations are not compelling, other factors may continue to serve as tailwinds. Foremost amongst these are the reform efforts being promoted by the Tokyo Stock Exchange (TSE) to improve capital efficiency and corporate transparency. Corporate engagement with these efforts has surpassed prior instances of attempted reform, with 57% of TSE Prime listed companies now having disclosed their planned initiatives. The actual and expected tangible results of these reforms include the increased return of capital to shareholders via dividends and buybacks, a reduction in cross-shareholdings, and a continued increase in the proportion of independent directors on boards. Additionally, a trebling of the Nippon Individual Savings Account allowance, which allows residents to invest in financial assets tax free, should be a source of greater inflows into domestic equities.

The TSE reform initiatives especially should be of particular benefit to Japanese small caps. Therefore, while we remain neutral on Japanese large caps, we see conditions in Japan as a tailwind to our DM ex US small-cap position, which counts Japan as its largest regional exposure.

Thomas O’Mahony, Senior Investment Director, Capital Markets Research