After the crash, where next for Japanese investors?

The latest volatility was triggered by a sharp appreciation of the Japanese yen against the dollar, a technical trading factor known as a “carry trade”.

This selloff came after a number of very strong years of performance for Japanese stocks, which were helped by the national currency hitting multi-decade lows against the dollar. The chart below shows US dollar returns over five years, including the pandemic and the October 2022 bull run – a period that coincided with further yen weakness. Most funds available to UK investors are still in positive territory for the year, as is the Morningstar Japan index, which is less than 1% higher year-to-date. Further stock market weakness could erode those gains for 2024.

Richard Kaye, portfolio manager of the gold-listed Comgest Growth Japan Fund, wasn’t too worried about the sharp sell-off in the market. The yen’s rally was “the fastest normalization I can remember,” he told Morningstar. And he argued that the stock market sell-off was more of a rotation out of index-heavy sectors such as banks and “yen plays,” stocks dependent on continued weakness in the domestic currency.

“In our view, the previous two years have been uneven, and the last two days are just a correction of that,” he added.

A buying opportunity for overseas investors?

Kaye had previously avoided buying Japanese banking stocks, and his portfolio remains focused on social infrastructure changemakers as well as providers of critical technology from semiconductors to components. Large caps such as banks and exporters have suffered from the sell-off, but Kaye is focusing on smaller-cap stocks.

“We have about a 30% small- and mid-cap weighting that we are strengthening and expect to benefit significantly from a stronger or normalizing yen as US yields decline.”

Hiroyuki Ueno, chief strategist at asset manager SuMi Trust, believes the cut provides an opening for new buyers, who were previously unable to exploit Japanese stocks at recent high valuations.

“Overseas investors who have been waiting for the yen’s appreciation to slow down are taking advantage of the current market volatility to enter the market,” he told Morningstar.

“There is a possibility that Japanese companies will use their ample cash reserves to initiate share buybacks during this period. If this becomes a reality, it will have a positive effect on market sentiment, which has been shaken by the volatility seen in August.”

There could also be interest from domestic buyers, he adds. In 2024, the upper limit of the tax-free scheme called NISA, which is like ISAs in the UK, was increased, triggering greater underwriting flows into the market by Japanese retail investors.

Investors are waking up to higher rates in Japan

For Carl Vine, portfolio manager of the Morningstar Bronze-Rated M&G Japan Fund, the volatility experienced in the Japanese market showed that investors have finally woken up to the fact that rates won’t be at zero forever. The Bank of Japan raised interest rates in early August for the second time this year; previously, the Asian central bank had not raised interest rates in 17 years.

“As is typical for such ‘volatility matches’, the correlations in both the downside and recovery tend to be very high. The opportunity for the investor is therefore to either find ‘bathwater baby’ situations or add beta portfolio,” he wrote in a note.

“In our case, we used both playing cards. We added in some names where the misselling was apparently illogical and related only to contagion. We also leaned modestly from defensive names to names that were being sold indiscriminately “, he says.

The normalization of interest rates in Japan, after more than two decades of experimental policy, was expected to lead to market turmoil.

However, he welcomed the volatility, which has pushed the price of Japanese shareholdings lower despite the “solid fundamentals” of the Japanese stock market.

Japan: A Divided Stock Market

James Salter, CIO of Zennor Asset Management and manager of the neutral-rated Zennor Japan fund, wrote in a note that the stronger yen will lead to a bifurcated market that will benefit some Japanese stocks over others.

“I suspect that last year’s ‘winners’ (will) jump in the short term, but then struggle. Many of these names are sensitive to the yen and exposed to the global economic cycle. Our portfolio remains, however, very domestically oriented. We will nibble on some existing names that have pulled out, but they are aware that deleveraging may have more to do.”

However, he does not expect the sell-off and yen appreciation to have a radical impact on Japanese competitiveness, arguing that investors will be better able to access top global companies undergoing a corporate governance revolution at lower prices.