Japan’s equity market see-sawed at historic levels over the last month or so, highlighting to investors how swings in sentiment, especially in thin summer markets, can disconnect stock prices from fundamentals.
While Japan, together with the US, were the two biggest casualties from the global market pullbacks seen in early August, the former’s travails initially began in July.
Tokyo’s Nikkei 225 Index peaked on 11 July at 42,224 before falling 10.8% and rebounding by 3.8% by the end of the month. Then in the early August pullback, the Nikkei fell another 19.6% in a few days, representing a peak to trough decline of 25.5%. On one of those days the Nikkei suffered a 12% drop, which was its largest decline since October 1987.*
But the recovery in the Nikkei was almost as dramatic as the fall: from its nadir on 5 August, it recovered 20.6% to close at 38,062 on 20 August.*
Hawkish signals from the BoJ
For some time, the Japanese yen has been through an era of weakness because of the low domestic interest rate, which has helped to drive Japanese exports and boost the economy by making them cheap. But in July the Bank of Japan (BoJ) raised its benchmark interest rate to 0.25%, its highest since the Global Financial Crisis in 2008, in order to tackle creeping inflation. This hawkishness rattled investors nerves and marked a major shift in global currency markets, sparking an unwinding in the carry trade, whereby investors would borrow yen at low interest rates and invest for higher returns elsewhere. The demand for yen to close out short yen positions added momentum to the currency.
BOJ Governor Kazuo Ueda faced intense market scrutiny on Friday (22 August) when he addressed the country’s lawmakers to explain the central bank’s hawkish signals that contributed to the global market turmoil (which was also closely linked to poor economic data in the US that were below expectations and prompted recession fears).
No change to our Japan ranking
Despite the recent turmoil on markets, our positive view on world markets, including Japan, remains unchanged.
It is unrealistic to think that the 225 companies listed in the Nikkei lost around a quarter of their fundamental value between July and August. More likely is sentiment, combined with thin volumes, provided an outsized level of sell pressures in the index. The performance of Japanese equities over the longer term also demonstrates their positive fundamentals. For example, over the three years to 20 August, the Nikkei delivered a total return of 48.2% in yen terms, and 17.3% in sterling terms, equating to annualised returns of 14.0% and 5.4% respectively.*
In our Tactical Asset Allocation, on a 12- to 18-month view, we rank Japanese equities, including small caps, as a positive four out five. We raised these rankings from a neutral three in the last quarter of 2023 because the inflationary regime in Japan, combined with improving corporate governance, could create a more positive environment for the economy and crucially, for equities to flourish. The inflationary environment that has set in for the first time in a couple of decades should encourage more consumption and, together with an improving corporate picture, the backdrop is constructive. Smaller companies should also benefit from these same broad themes with additional sensitivity to the domestic economy.
Japan’s stock market has waited more than three decades for its moment in the sun. It has benefited from relatively cheap valuations, a long-awaited return of inflation and, until recently, a weakening currency.
Given the sustained increases that Japanese and US equities have had over the past couple of years, it was perhaps unsurprising that these were the two major markets most affected by the August pullback. Swings in sentiment inevitably result in price movements. But volatility can also present opportunities for investors with a long-term view. History has shown that while investors will experience market dips and volatility from time to time, these events won’t stop the long-term positive performance of markets that have strong fundamentals.
*Source: Bloomberg, 21 August 2024
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