Multi asset weekly: is the Japanese equity rally running out of steam?

Global equity markets have recorded a strong start to the year, helped by signs of more resilient macro data and peaking inflation. Over recent months, Japanese stocks have performed particularly well, with the Nikkei rallying to the highest levels since the 1980s.

There have been some domestic drivers behind this recent Japanese outperformance and this rally has been supported by corporate earnings (chart 1). As well as supportive global macro backdrop, improvements in corporate governance and return on equity have been welcomed by investors, with Warren Buffet among those who have expressed bullish sentiment on the Japanese market in the last month.

Another key driver of Japanese equity outperformance is the Japanese yen, as export-oriented companies benefit from currency weakness. Over the first half of this year, the yen weakened by 10% versus the US dollar, which provided a great support to the local equity market.

Yen weakness has been largely driven by the policy differentials between Japan and the rest of the world (chart 2). While central banks in the rest of the world have undertaken rapid policy tightening and increased interest rates, the Bank of Japan have kept monetary policy loose and kept on buying Japanese government bonds to stop yields rising under a yield curve control (YCC) policy. A widening interest rate differential has put pressure on the currency as investors have sought higher interest elsewhere.

This interest rate differential may be reversing, and we no longer have a negative view on the yen (at least for now). Softer US inflation data and more mixed growth picture shows that we may be close to the peak fed funds rate over in the US, while in Japan, we expect further evidence of sustainable inflationary pressure in Japan to put an end to the Bank of Japan’s YCC in the current form.

We have been positive over the last few months, but we believe that a turn in the yen may see Japanese equity outperformance subside.  

Chart 1:Strong earnings growth has underpinned this rally in Japanese stocks

Source: Refinitiv Datastream as at 17 July 2023

Chart 2: Japanese yen has weakened as the rate differential between Japanese and US rates has grown more negative

Source: Refinitiv Datastream as at 17 July 2023

Market summary

Last week, global stocks gained in a broader cross asset rally amid a softening in US Consumer Price Index (CPI), Producer Price Index and initial jobless claims. Rate-sensitive growth sectors outperformed globally, and equity volatility fell with VIX trading back around 13. Equity regions which have struggled year to date, Asia Pacific and emerging markets outperformed. Commodities rallied broadly: brent benefitted from a pickup in Chinese oil imports and base metals witnessed the largest weekly gain in 2023 so far.

Economics summary

US CPI came in lower than expected, increasing confidence that we are close to peak US interest rates. In the UK, however, labour market data was soft but wage growth strong. CPI data this week will be important for expectations around the August Bank of England meeting. GDP data confirmed that China slowed in the second quarter; analysts continue to expect further policy support.

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