Changing economic circumstances could alter the market impacts of currency weakness, say experts Masaki Taketsume, George Brown and Robbie Boukhoufane.
The first third of 2022 has been challenging for markets in general, which is perhaps unsurprising given the many sources of uncertainty and contention around the world.
A very sharp depreciation in the value of the yen, however, will have potentially made a difficult period all the more difficult for foreign investors in Japanese assets. They might have felt the brunt of the decline in the yen if they hadn’t hedged against currency volatility.
On a more encouraging note, in “local currency” terms (see chart below), Japanese equities held up relatively well. The local currency terms provide a picture of the performance of the underlying market, as they eliminate the impact of exchange rate movements experienced by investors other than the yen.
This resilience relative to some other developed markets may partly reflect hopes that a weaker yen will boost Japan’s export-heavy economy.
Still, experts caution against drawing any firm conclusions about currency impacts, especially in light of some changed economic circumstances in Japan.
The return of inflation after two decades of absence worries consumers accustomed to falling prices or deflation. Its reappearance also highlights some of the economic complexities at play, including the country’s increased energy dependence since the Fukushima nuclear disaster in 2011.
George Brown, Economist, said: “A weak yen has always been encouraged by Japan’s industrialized economy. But years of offshoring and increased energy dependence meant that its 13% drop this year was met with more concern than celebration.
“Offshoring” refers to the process by which many Japanese manufacturers moved their factories to lower-cost countries. The weak yen offers fewer opportunities for the economy as the benefits for international competitiveness have been reduced.
Japanese corporate profits continue to grow overall
A falling currency, however, is potentially more of an inflationary threat than in the past. This is largely due to the country’s increased dependence on imported energy following the Fukushima accident, with many nuclear power plants being dismantled.
The sharp rise in energy prices following Russia’s invasion of Ukraine highlighted these risks.
Robbie Boukhoufane, Bond and Currency Portfolio Managersaid: “Japan is vulnerable to a sharp rise in commodities as imports continue to climb – driven by soaring energy prices – while export gains have also slowed.”
Inflation is not expected to reach rates comparable to rates currently seen in Western developed markets. While consumer price inflation is expected to jump to near the Bank of Japan’s (BoJ) 2% target over the next two months, this is by no means a peak. important in absolute terms.
But even moderate rates of price growth could prove difficult for some companies and sectors, especially given the likely resistance of consumers to higher prices.
Experienced investors are currently focused on finding the companies most likely to raise the prices of their end product to offset any impact on earnings.
They noticed that firms are beginning to test their so-called “pricing power” as their own input, or “output prices” continue to rise. These prices have already been on an upward trajectory for some time, with Japan also struggling with Covid-related disruptions.
Masaki Taketsume, Japanese fund managersaid: “We have recently seen anecdotal evidence of companies seeking to pass on these increases to the prices of finished products.
“However, their ability to fully defend their margins by passing on cost increases is still questionable, as domestic consumers remain highly price-sensitive after two decades of deflation.
“Certain particular sectors may struggle in this environment, such as retailers who are exposed to the end consumer and transport companies, where fuel represents a significant portion of their costs.”
That said, Taketsume remains confident in the ability of Japanese companies as a whole to increase their profits this year.
“Overall, we are confident that aggregate earnings for companies in the listed sector can continue to grow, potentially reaching new highs in fiscal 2022.”
Monetary policy stance seems set
Inflation is not expected to become the threat to price stability seen in the West, where concerns are pushing central banks to aggressively “tighten” monetary policy.
Granted, the pundits remind us that the impending rise in annual consumer price inflation to close to 2% is partly technical in nature, not just the result of yen weakness.
For example, political reductions in mobile telecommunications tariffs in previous years had a one-time effect of reducing inflation, which is now removed from annual calculations.
“How long a level close to the Bank of Japan’s 2% target is maintained, and the ultimate peak of inflation in this cycle, depends particularly on energy prices, but we still see reasons structural constraints to limit any larger rise in inflation in Japan,” Taketsume said.
Economist Brown agrees. “Given the underlying economic conditions, there are few signs that inflation will take off this year or next.” Conversely, however, he does not foresee any significant change in monetary policy that could cause a reversal in the yen and ease some of the inflationary pressures.
Japan’s monetary policies look set to continue to weigh on bond yields. This lessens the attractiveness of Japanese government bonds, or JGBs (and demand for the yen) relative to government bonds in other major developed economies.
In the US, for example, the dollar appreciated as Treasury yields rose in response to tighter US Federal Reserve (Fed) policy.
Japan’s ruling LDP party is aware of consumer concern over rising prices that are hurting its prospects for July’s Upper House elections, Brown said, but any intervention is likely to be ineffective.
“There is speculation that Tokyo could use its foreign exchange reserves to try to support the yen for the first time since 1998,” Brown said.
“However, it will struggle to make much progress as long as the Bank of Japan breaks with its global peers by maintaining its ultra-accommodative policy.”
In April, the BoJ doubled down on its choice of “unconventional” monetary policies (in its case, yield curve control) to be achieved by unlimited purchases of 10-year JGBs.
Inflation not top concern for Japanese policymakers
All major central banks deployed unconventional policies in the wake of the global financial crisis when conventional policies such as lowering interest rates were exhausted. They then reactivated these programs in response to pandemic-related shutdowns.
Most have either terminated these plans or are about to reverse them in the case of the Fed in a process of monetary “normalization”.
Central banks have accumulated large amounts of government bonds under quantitative easing (QE) programs – the purchase of these bonds has been used to inject money directly into the financial system. These stocks on their balance sheets now seem destined to be gradually reduced to be sold on the market.
The direction of travel west, however, contrasts sharply with the BoJ’s intentions to add more JGB to its balance sheet.
This situation seems unlikely to change in the short term, says Boukhoufane.
“While there have been some concerns about the speed of the yen’s recent decline, policymakers are less concerned about inflationary pressures than in other countries,” he said.
Overall, a more nuanced picture may be emerging, which could complicate the historical tendency for Japanese equities to perform well when the yen is weak (see chart below).
However, overall earnings of listed Japanese companies should still hold up during this turbulent period, while careful selection of individual investments may be in demand.
Past performance is not indicative of future performance and may not be repeated. The value of investments and the income from them can go down as well as up and investors may not get back the amount originally invested.