Japan’s equity market has suffered more than other developed markets in 2016, with the overriding factor being the significant appreciation of the country’s yen, a consequence of its perceived ‘safe-haven’ status.
The Japanese currency has followed a remarkably close path to the Nikkei 225 index, albeit inversely, appreciating by 14 per cent against the US dollar this year compared with the Nikkei’s 18 per cent fall – at June 30 2016. This period of yen strength has been in spite of the Bank of Japan’s (BoJ) efforts to depreciate the currency through a negative interest rate policy.
History shows that Japan’s equity markets are notoriously volatile and cyclical, and often characterised by episodes of hope and euphoria only to be replaced by periods of disillusionment. We have certainly witnessed this episodic rise and fall in the past 18 months.
The Nikkei 225 index gained 43 per cent between its low in October 2014 and the high in August 2015 in local currency terms, spurred on by aggressive BoJ easing and hopes of overdue reform through so-called ‘Abenomics’. However, when China’s central bank allowed a depreciation of the renminbi in August 2015, global risk aversion took hold on concerns that Chinese authorities were losing control of the nation’s economic slowdown.
Capital started to flow back into the yen in response to further steep falls in oil prices, on disappointing global economic data and uncertainty surrounding the future path of US interest rates.
| KEY NUMBERS |
14%: Appreciation of the Japanese yen versus the US dollar this year £41m: Net retail outflows from IA Japan sector equity funds in May 2016 -0.1%: Negative interest rate level in Japan as of July 25 |
As well as global considerations, the domestic macro environment remains a source of perennial disappointment. The strength of the Japanese yen has not helped and, combined with slower global growth, has constrained exports and manufacturing output. Private consumption remains subdued despite tight labour market conditions.
Moreover, the BoJ’s stimulus efforts to reflate the economy are being overwhelmed by the strength of the yen, which is putting downward pressure on prices. The structural economic reform agenda has also slowed, and without the political capital to effect change, the longer-term challenges of ageing demographics and a shrinking working age population seem insurmountable.
It is easy for equity investors in Japan to become despondent. Nonetheless, despite all of the macro shortcomings, there is a longer-term positive investment case in the micro story. Changes are occurring within corporate Japan and there has been a strong focus on improving shareholder value and governance.
Although the share price performance of large-cap, export-orientated companies has been pressured in the past few months by yen strength, other sectors and stocks exposed to a ‘new’ Japan have told a different story, particularly among smaller caps.
The Tokyo Stock Exchange Mothers index has increased 30 per cent this year, to June 30, in local currency terms and 49 per cent in sterling terms – all of this upside occurring since mid-February. What is telling is the sector make-up of this index: nearly 50 per cent is in healthcare, 32 per cent in IT and 11 per cent in consumer discretionary.
Investors are tapping those firms that are able to exploit and benefit from structural societal shifts occurring in Japan and which can potentially create long-term value.
The narrative of Japanese equity markets in the past few months is therefore rather more nuanced than the headlines suggest. Given that we are likely to see an easier monetary and fiscal stance in coming months, expect recent yen strength to be unsustainable over the longer term.
Investors should now consider it prudent to start partially re-hedging some of their Japanese equity exposure.
Michael Stanes is an investment director at Heartwood Investment Management
