Japanese equities have just experienced one of their biggest ever drawdowns. Carl Vine, Co-Head of Asia Pacific Equities, examines the causes of this market volatility and the potential implications for investing in Japan’s stock market.
Mr and Mrs Risk recently paid an impromptu visit to the Japanese Equity market. Seemingly, they were in a bad mood. The result was one of the biggest three-day drawdowns in the market’s history. What happened – and what is the market telling us?
“Market drawdowns of this magnitude are typically associated with major and unexpected economic events.”
Market drawdowns of this magnitude are typically associated with major and unexpected economic events: the Lehman crisis, the Great East Japan Earthquake, the Covid-19 crisis and so on. In this case, it would appear that we are talking more about a butterfly effect of complicated, global, cross-asset correlations than an unexpected economic iceberg; more 1987 than 2007.
Yen strengthening
On 31 July, the Bank of Japan (BOJ) raised the policy rate from 0-0.1% to 0.25%, the highest level since 2008. Despite flagging a possible increase in interest rates since December 2022, this was somehow slightly more hawkish than the consensus expected.
At the same time, whilst the Federal Reserve (Fed) itself said nothing, economic releases in the US resulted in a dovish shift in Fed-funds rate expectations. The confluence of the two reverberated through FX markets and the yen, finally, started to strengthen.
As this unfolded, short term and aggressive volatility-contagion ensued. Japanese equities were at the tip of this spear, but regional equities across Asia also experienced ripples. The long-short equity community in particular appears to have unwound exposures rapidly.
Structural improvement continues in Japan
What can we decipher from these moves? At the fundamental level, arguably not much. It seems fair to say that global markets have become somewhat more concerned about US growth. As the world’s largest economy, this bears serious consideration. In Japan, whilst this should not have been new news, the market is finally getting the message that rates will not be zero forever. Beyond this, it would seem the moves speak more to financial market positioning rather than a sudden and meaningful shift in the fundamental, economic reality.
Despite unusual volatility, sentiment on the ground in Japan has been relatively calm. The Japanese economy continues along its path of structural improvement, especially in the listed corporate sector. Stock market earnings remain solid thanks to genuine self-help and ongoing structural reform of business models and capital policies. Earnings grew some 12% in the last financial year and earnings in the current fiscal year appear to be off to a strong start.
Opportunities from volatility
What are we doing following these moves? As is typical of such “volatility fits”, correlations in both the downdraft and the recovery tend to be very high. The opportunity for the investor, then, is to either find “baby-out-with-the-bathwater” situations, or to add portfolio beta.
In our case, we have used both playbooks. We have added to some names where undue selling was seemingly illogical and related purely to contagion. We have also tilted modestly away from defensive names towards stocks that, in our view, were being sold indiscriminately.
We are not in the business of predicting market episodes, but we are alert to their ongoing possibility. Indeed, we have noted a number of times in the past that it would be heroic to expect the normalisation of interest rates, after 20-plus years of experimental policy, to happen without the market slipping on an occasional “banana skin”. Well, this just happened – and that’s ok.
With weak hands seemingly flushed out in recent days, the price one must pay for equity ownership in Japan has shrunk despite robust fundamentals. We remain of the opinion that Japanese equities represent an attractive, structural investment opportunity with an asymmetric prospective payoff profile.
The value of investments will fluctuate, which will cause prices to fall as well as rise and investors may not get back the original amount they invested. Past performance is not a guide to future performance. The views expressed in this document should not be taken as a recommendation, advice or forecast.