(News Bulletin 247) – The Japanese market suffered at the end of July and especially at the beginning of August from the unwinding of the carry trade and the variations in the yen, even if it then made up a large part of its losses. For Bank of America, Japanese stocks will take time before returning to their records. But the medium-term horizon seems promising.

To say that Japanese stock markets have been shaken this summer is an understatement or an understatement. The Tokyo Stock Exchange made headlines in mainstream media when the benchmark Nikkei 225 index fell 12.4% in one session on August 5, a historic plunge, before recovering 10% the next day.

Let us recall that before this tumultuous episode, the Japanese stock markets were posting dizzying performances, whether over the whole of 2024 or even over several years, to the point of outperforming the American market as a whole.

Japanese stocks have benefited from several tailwinds, including the return of inflation in a country that has long struggled to boost prices and avoid deflation. In addition, Japanese stock market authorities have issued guidelines, often using name-and-shame tactics, to encourage listed companies to improve their governance and return-on-capital performance. To give a concrete example, the Tokyo Stock Exchange has asked companies that trade below their book value (a price-to-book ratio below 1) to submit a plan to turn things around.

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The “carry trade” in question

But another undeniable performance factor for Japanese stocks remains the fall of the yen. As Cyrille Collet of CPR AM recalled on News Bulletin 247 last week, the dollar went from 110 yen to 160 yen between 2020 and 2024. This resulted in “an upward revision of Japanese companies’ forecasts because we are in a very export-oriented, very industrial economy,” he explained. This led Japanese companies to post profit growth that was significantly higher than that of American groups or emerging Asian countries.

This is where the market mechanism behind the aberrant volatility experienced by the Tokyo Stock Exchange this summer comes into play: the “carry trade” or carry strategy. This market mechanism consists of borrowing funds in a country where interest rates are low to place them in a country where they are higher, and thus playing on the differences in the remuneration of the funds.

For a long time, investors played the “carry trade” by borrowing yen, Japan being one of the few countries to have maintained very low rates in 2022 and 2023, to place their funds in dollars or in emerging countries. This is why the yen had fallen so much.

But the Bank of Japan’s rate hike at the end of July, coupled with expectations of rate cuts by the Fed following poor US statistics, particularly the July employment report, led investors to suddenly unwind their positions. And thus to sell dollars (or emerging country currencies) to buy yen. This is what (largely) explained the surge in the yen at the end of July – beginning of August and, by ripple effect, the fall in Japanese stock markets.

Stocks still attractive

Since then, Japanese stocks have rebounded. Investors were reassured in early August by a statement from a deputy governor of the Bank of Japan who assured that the institution would not raise its rates if the financial and capital markets are unstable. But the Nikkei 225 remains far from its records reached earlier in the year. The flagship index of the Tokyo Stock Exchange currently stands at 38,800 points, against a peak of 42,426.77 points, a gap of 8.5%.

What to expect next? Speaking to CNBC this week, JPMorgan AM’s Tai Hui said there is “a robust scenario” for continued investment in Japanese stocks. The market expert argues that corporate earnings are improving and that Japanese companies have taken “a lot of actions that tell us that Japanese companies are gradually changing the way they operate for the benefit of shareholders.”

The specialist particularly mentions the implementation of a hedging strategy against exchange rate risk. And underlines that the shares of Japanese groups are still attractive in terms of valuation. This is also evidenced by the offensive of the Canadian distributor Couche-Tard which, after failing to get its hands on Carrefour in France in 2021, set its sights on Seven & I, which owns the “konbini” (very popular Japanese convenience stores) 7-Eleven.

Risks still present

In a Q&A note published last week, Bank of America believes that some of the factors behind the rise in Japanese markets, such as the return of inflation, are likely to persist. The American institution points out that Japanese households are sitting on $15 trillion in financial assets, half of which are deposited in current or interest-bearing accounts, compared to 13% in the United States and 36% in Europe. If inflation continues, this windfall should gradually be deployed towards risky assets, including stocks.

Ultimately, Bank of America expects that the Japanese market, even if it is in a recovery phase, “will take time” before breaking its records again. “In the medium term, we believe that the evolution towards an inflationary environment and the acceleration of reforms at the corporate level will lead to a sustained recovery,” the American bank nevertheless adds.

Risks obviously persist. Quoted by Bloomberg, JPMorgan estimated on August 8 that 75% of the “carry trade” positions had been unwound. But the evolution of the yen must still be monitored.

“The risk is still present if the Bank of Japan raises its rates again and the Fed (the American Federal Reserve, editor’s note) lowers them. It will depend on what they (the Japanese, editor’s note) want to do with inflation and the speed at which the Fed lowers its rates,” Cyrille Collet stressed. The latter notes, however, that most brokers “are relatively peaceful on the subject” with a dollar-yen rate expected at 140 at the end of 2025, against 146 currently.

However, bouts of volatility are to be expected. Since the beginning of August, the yen-dollar has been experiencing significant fluctuations in one session. The Japanese currency notably gained 1% on Tuesday after the governor of the Bank of Japan, Kazuo Ueda, reiterated that the institution would raise its rates again if the Japanese economy follows the trajectory he anticipates. The following day, the Nikkei 225 lost 4.2%.

One factor, however, could deter the Bank of Japan from raising rates in the short term: political uncertainty. Japanese Prime Minister Fumio Kishida has confirmed that he will not run for the presidency of the ruling LDP party, with an election due later this month. He will effectively have to leave the government.

“We expect that political uncertainty ahead of the upcoming election for the leadership of the ruling Liberal Democratic Party (LDP), and the possibility of early general elections will prevent a rate hike” in the fall, said Lee Hardman of MUFG, quoted by AFP.