January 29, 2024
The Nikkei 225 strongly outperforms global indices
To benefit, investors must hedge against the depreciation of the yen
Will this trend continue ?
The answer can be heard in the corridors of the Bank of Japan... and it's a "yes"

CHART OF THE WEEK: "The yen's slide is a major boost for the Nikkei"


Over the past two years, Japanese equities have clearly outperformed global stock markets. The Nikkei, Japan's main index, has just reached its highest level for 33 years, contracting modestly in 2022 (-9%) before rising 28% in 2023. Since the start of 2024, it is already up 8%, compared with 2% for the US S&P 500 and 0.5% for the Euro Stoxx. Even the Nasdaq's 3% rise looks stunted by comparison. Some investors are trying to justify the Nikkei's outperformance by pointing to the resilience of the Japanese economy (see Fig. 2), underpinned by robust domestic demand, the resurgence of tourism and the return of inflation. Our analysis leads to a far less glorious explanation: the outperformance of Japanese equities is exclusively the consequence of the yen's fall (see Chart of the Week & Fig. 3). The correlation coefficient is 95%.

Fig. 2 - Economic activity in Japan - Fig. 3 - USD/JPY exchange rate
Fig. 2 - Economic activity in Japan - Fig. 3 - USD/JPY exchange rate

The depreciation of the yen makes Japanese exports more competitive in international trade. This advantage has been a driver of earnings growth for major companies and has been reflected in their share prices (see Fig. 4). In other words, by adjusting stock market performance for exchange rate movements, the Nikkei is perfectly in line with world indices. The outperformance disappears (see Fig. 5).

Fig. 4 & 5 - Performance of global equities, currency adjusted or not
Fig. 4 & 5 - Performance of global equities, currency adjusted or not

To know whether they should continue to overweigh Japan in their asset allocation, investors therefore need to forecast the yen. If the currency is set to appreciate, then Japanese stocks will underperform. Conversely, if the currency falls further, Japanese equities will continue to outperform (as long as the yen exposure is hedged). This analysis leads us to two key concepts: debt deflation and unconventional money printing by the Bank of Japan (BoJ).

In 1933, four years after the Great Depression, the economist, Irving Fisher, identified the problem of debt deflation. He demonstrated how a process of debt reduction led to a sharp fall in consumption, capital expenditures, and public spending, and therefore in growth, and how this process was likely to plunge the economy into a deflationary recession. A vicious circle is triggered because, in a deflationary situation, the real burden of debt mechanically increases, leading economic agents to redouble their efforts to reduce their debt. Then, everything depends on their confidence in the sustainability of this debt. As long as confidence remains high, debt deflation will continue (see Fig. 6). If confidence collapses, the scenario of hyperinflation and devaluation begins (see Fig. 7).

Fig. 6 - Deflation through debt - Fig. 7 - Hyperinflation through devaluation
Fig. 6 - Deflation through debt - Fig. 7 - Hyperinflation through devaluation

Deflation: Japanese-style scenario between 1992 and 2020

▪ Investors continue to have confidence in the State, buying up sovereign debt on a massive scale

▪ Deflation is sustainable because revenues are saved rather than invested or consumed

▪ Growth is stalling, fuelling deflation and the debt burden

▪ The currency appreciates, thanks to Purchasing Power Parity (PPP)

▪ Savers end up liquidating their assets when they themselves become indebted

Devaluation: "emerging country", "1929 crisis", or "Japanese-style since 2021" scenarios

▪ Investors lose confidence in the State, preferring foreign assets (capital flight)

▪ The central bank becomes the main buyer of sovereign debt

▪ The national currency depreciates massively or is devalued

▪ Hyperinflation is generated by rising import prices and economic uncertainty

▪ Growth finally rebounds but savers have been robbed

Above a certain level of debt, investor confidence breaks down. They feel that they face a high risk of default and, in the case of Japan, they move away from yen-denominated sovereign bonds (JGBs). This weakness in demand is pushing up interest rates. The Japanese Treasury is forced to pay investors more if it hopes to find buyers for all its bond supply. This rise in the risk premium and associated interest rates is putting the brakes on the economy: the government is trying to reduce its deficit, companies are no longer borrowing to invest and households are saving rather than consuming. Recession and deflation set in, making the debt problem even worse.

To remedy this inevitability, the central bank has no choice but to intervene as its mandate is to keep inflation in positive territory. To do this, it artificially lowers interest rates through 'Yield Curve Control'. The BoJ prints yen and then buys all Japanese sovereign bonds with yields above a predefined level, 0.1% between September 2016 and March 2021 for example. By doing this, it makes the debt sustainable and encourages investment and consumption rather than savings. In this way, it avoids defaulting on payments while supporting growth in economic activity and prices. The disadvantage of this policy is that it creates major distortions in the markets. Money printing depreciates the value of the yen. If, as the saying goes, "everything that is rare is expensive", on the other hand everything that is abundant is of little value.

Fig. 8 - Over/undervaluation of the USD/JPY exchange rate
Fig. 8 - Over/undervaluation of the USD/JPY exchange rate

Usually, when debt and deflation are self-perpetuating, the currency appreciates. This is what happened between 1992 and 2020 in Japan. The theory of PPP stipulates that the prices of goods and services must be the same everywhere on the planet, otherwise currencies will move to compensate. So the lower inflation is in a country, the more its currency appreciates. And vice versa. Historically, with price growth lower in Japan than elsewhere, the yen has a natural tendency to appreciate. Since 2021, this has no longer been the case. If the theory were to continue to apply, then the exchange rate of the dollar against the yen would be 80. Today, the greenback is trading at 147 yen. The Japanese currency seems a long way from its fair-value (85% above, see Fig. 8). The gap is so wide as to be impressive. One of two things is true: either this is the opportunity of the century for forex traders, or something has broken in the valuation of the yen.

It seems that the Japanese central bank is unable to put an end to its unconventional monetary policy (YCC). In 2023, the BoJ bought around 70% of the new debt issued by the Japanese government. Cumulatively, it holds 49% of all sovereign bonds and treasury bills, compared with 'only' 10% in 2012. How could the BoJ reduce or even halt this strategy? In 2021, 2022 and even more in 2023, it has tried to do so. It allowed 10-year bond yields to rise from 0.1% to 1.0%. This higher yield should have attracted private investors: insurance companies, banks, pension funds, investment funds and so on. This has not worked (see Fig. 9). Over the past two years, the proportion of Japanese public debt held by the BoJ has risen steadily, from 43% to 49%. Investors no longer want to buy Japanese debt.

Fig. 9 - Japanese public debt held by the BoJ and 10-year yields (inverted)
Fig. 9 - Japanese public debt held by the BoJ and 10-year yields (inverted)

Conclusion :

Contrary to what it regularly announces, the BoJ will not be able to normalise its monetary policy by relaxing the 'Yield Curve Control' (YCC), and even less by abolishing it, as some investors regularly expect. So the yen has not finished its depreciation. At this stage, it should even be called a devaluation. Ironically, Japanese equities (hedged) have every chance of continuing to outperform global equity indices.

Financial Research