Insights into the Japanese equities market sell-off
Junichi Inoue, Head of Japanese Equities, discusses the multiple triggers that led to the recent sharp market sell-off.
6 minute read
Key takeaways:
- Following a stellar performance year-to-date, the recent drastic drop in Japanese equities has led investors to consider re-evaluating their holdings and investment approach.
- There were multiple causes for the sell-off including the unwinding of the yen carry trade, overseas profits not repatriated and converted into yen, overenthusiasm for AI-related stocks, and one-way bets for yen depreciation.
- While continued short-term volatility can be expected, the sell-off has created mispricing opportunities for active investors, who can also unlock further shareholder value by engaging with companies to improve their corporate governance and capital efficiency.
On August 5th 2024, the Nikkei 225 Index saw the second largest drop in its history. The largest drop was on Black Monday in 1987, followed by the 2008 Global Financial Crisis (GFC) in third place, the 2011 Great East Japan Earthquake in fourth, and the 1953 Stalin crash in fifth. But how will the recent 12% one-day drop be remembered in the future? Could it be known as the Bank of Japan (BoJ) rate-hike shock? The timing of the second hike was two months earlier than the market predicted, but followed a predetermined course, and the second hike was lower, at only 15 basis points.
Unexpected scale and speed of yen carry trade unwinding
Currently, the most supported headline explanation for the massive drop by market commentators is the unwinding of the yen carry trade. However, it’s difficult to clearly capture the scale of the yen carry trade and its main participants. One securities company claimed that all trades have been unwound, while another stated only 30% has been unwound. The reality is that the true extent of the yen carry trade is unknown because most foreign exchange (FX) trading is still executed over-the-counter (OTC), meaning trading data is less available and reliable. And for the most part only commodity trading advisors (CTAs) use FX futures, which have more transparency since they’re regulated and traded on the open market.
For now, the immediate panic is over. The majority of CTA and momentum-driven investors’ positions appear to have been closed out (yen short positions in FX futures have been covered and speculative yen positions are now flat). This means that the FX impact on profits earned by Japanese companies overseas have largely been minimised.
Overseas profits are not being repatriated and converted into yen
A visit last month to an exporting company that earns most of its profits in the US provided some interesting insight. The CFO revealed that the company had not repatriated any profits earned in the US over the past three years. Dividends and share buybacks were financed with low-interest yen, while interest earned on their profits came from parking these funds in time deposits in the US, which amounted to a few trillion yen. Many companies like this hold US dollar deposits equivalent to a single FX intervention. Additionally, the interest and dividend income earned overseas by Japanese institutional investors is generally reinvested in local currencies. However, extreme yen depreciation and an aging population could lead to yen conversion. In our view, this broader definition of the yen carry trade is overlooked in the structurally weak yen theory.
Market overwhelmingly calling for yen depreciation
We also think that another factor that led to the market correction is the homogenisation of investment behaviour. For example, the yen had been trading at historical levels of deviation from purchasing power parity rates, presenting a level of undervaluation comparable to just before the Plaza Accord was signed in 1984 (which is believed to have contributed to the Japanese price asset bubble in the late 1980s). Despite this, the yen continued to weaken against the backdrop of the Japan-US interest rate differential, and calls for yen appreciation were overcome by structural yen depreciation theories.
AI-fuelled boom driving crowded trades
Also, the semiconductor manufacturing equipment sector in Japan was a crowded trade, riding on the coat-tails of the AI-related stock boom. While many of these companies undoubtedly possess competitive strengths, many were trading at stretched valuations (prices). Related to this, the market-wide success of trend-following investment strategies over time has made investing with a valuation discipline more challenging. This set the stage for a correction, with market sentiment already fragile due to sharp falls in AI-related stocks in the preceding weeks, and the US Federal Reserve’s decision to hold rates at high levels even as US employment data was beginning to weaken rapidly.
Against this backdrop, the confluence of the above-mentioned triggers and weeks later, the Bank of Japan’s end July rate hike, which (for some) came as a surprise in terms of timing, led to a massive sell-off, especially in those stocks that had made strong year-to-date gains. Many hedge funds with high leverage and a low pain threshold for losses (and where they also operate on a calendar year profit & loss) were forced to liquidate leveraged positions quickly, exaggerating the size of the moves. This episode exposes the dangers of betting on trends rather than focusing on company fundamentals like earnings and valuations.
Yen appreciation can be a positive
Looking forward, following the yen’s correction, the market is more wary towards a one-sided bet on yen depreciation. Structural theories on Japan’s trade deficits are highlighted, but the current account surplus is currently at a record high, while interest rate differentials are shrinking. Further, an appreciating yen could, in fact, lower input costs and help curb inflation. We believe it may also reduce corporate margin pressure, and lead to sustained wage increases. Should this scenario play out, the BoJ can conduct monetary policy based on inflation rates without being swayed by exchange rates. Although yen appreciation is in theory a negative for exporters’ performance, the stock market didn’t discount this factor in their stock valuations when the yen-US spot rate hit 160. Therefore, the impact on the market’s view of fair value of below 150 could be limited – the recent market drop has seen the yen fall well below this level.
Volatility-created opportunities
On a positive note, we see opportunity amid the recent volatility. The rapid movement in capital markets has reduced the market’s risk tolerance; leading to a more cautious market and reconsideration of one-way bets on yen depreciation. Meanwhile, a transformation of corporate governance and capital efficiency is underway in corporate Japan, which we believe is in the process of unlocking substantial hidden value for investors. While we expect continued volatility in the short term, the recent drop has enabled us to identify many mispriced stocks. In the medium term, we think the Nikkei’s recovery can offer attractive opportunities to generate excess returns from the world’s second largest stock market.
Basis point: one basis point equals 1/100 of a percentage point. 1 bp = 0.01%, 100 bps = 1%.
Commodity trading advisor (CTA): a US-specific term referring to investment companies and hedge funds that invest in trend-following/systematic/quantitative strategies by trading futures and other derivatives (known as managed futures) in underlying assets such as commodities, equities, currencies, indices and interest rates.
Corporate governance: a set of rules, practices, and processes used to run and control a company. This includes key areas such as environmental awareness, ethical behaviour, corporate strategy, compensation, and risk management.
Dividends: a variable discretionary payment, typically cash, taken from the company’s profits to reward shareholders for investing in the company.
Leverage: (in the context of this article) is the use of borrowing to increase exposure to an asset/market. This can be done by borrowing cash and using it to buy an asset, or by using financial instruments such as derivatives to simulate the effect of borrowing for further investment in assets.
Monetary policy: a central bank uses monetary policy to try and influence the level of inflation and growth in an economy. Monetary policy tools include setting interest rates and controlling the supply of money.
Over the counter (OTC): the trading of securities such as equities, bonds, currencies or derivatives directly between two parties rather than a formal centralised exchange.
Plaza Accord: a joint agreement signed on September 22, 1985 between France, West Germany, Japan, the United Kingdom, and the United States, to depreciate the US dollar relative to those  countries’ currencies. The aim was to counter the US dollar’s rising appreciation and reduce the trade deficit between countries.
Purchasing power parity: the rate at which the currency of one country would have to be converted into that of another country to buy the same amount of goods and services in each country.
Short position: shorting is used with the intention of making a profit or to offset a financial risk. In currency trading, a long position is taken on one currency and a short position on another. Currencies are traded in pairs with their value in relation to each other determining if a trader makes a profit. A trader may also short a currency solely to profit from a fall in the value of the currency.
Nikkei 225 Index: also known as Nikkei Stock Average, is a price-weighted equity index consisting of 225 stocks in the Prime Market (companies that centre their business on constructive dialogue with global investors) of the Tokyo Stock Exchange.
Share buybacks: a company buying back its own shares from the market, thereby reducing the number of shares in circulation, with a consequent increase in the value of each remaining share. It increases the stake that existing shareholders have in the company, including the amount due from any future dividend payments. Buybacks typically signal the company’s optimism about the future and a possible undervaluation of the company’s equity.
Spot rate: the exchange rate for a currency at the current time.
Volatility: the rate and extent at which the price of a portfolio, security or index, moves up and down. If the price swings up and down with large movements, it has high volatility. If the price moves more slowly and to a lesser extent, it has lower volatility. The higher the volatility the higher the risk of the investment.
6 minute read
Key takeaways:
- Following a stellar performance year-to-date, the recent drastic drop in Japanese equities has led investors to consider re-evaluating their holdings and investment approach.
- There were multiple causes for the sell-off including the unwinding of the yen carry trade, overseas profits not repatriated and converted into yen, overenthusiasm for AI-related stocks, and one-way bets for yen depreciation.
- While continued short-term volatility can be expected, the sell-off has created mispricing opportunities for active investors, who can also unlock further shareholder value by engaging with companies to improve their corporate governance and capital efficiency.