Equities

Expect more Japanese market volatility, and embrace it

August 22, 2024 - 4 min read

Portfolio Manager and Senior International Investment Analyst – Harris | Oakmark

On Monday, 5^th August the Japanese stock market dropped 12%. This was off the back of two days of heavy losses, leaving the Nikkei 225 down 20% over three days, its biggest drop since 1970. The next day stocks rebounded 10%.

In my 15 years covering Japan I have never had more clients ask me about my thoughts on the Japanese equity market. While the size of the moves in Japanese equity markets were surprising to us, the volatility itself was not. There are fundamental changes happening in the Japanese economy and the market is adjusting.

We don’t pretend to have all the answers, more will be uncovered in the months and quarters ahead, but we believe there is strong evidence to support the following:

A paradigm shift is happening in Japan that is causing extreme volatility.

On Wednesday, 31 July the Bank of Japan raised interest rates for the second time in 17 years and signaled further rate rises to come. While the rate rise was not unexpected it is still a significant change for Japan, which now has positive interest rates for the first time since the late 2000s. Ultra-low interest rates have been normal in Japan since the late 1990s, when the BOJ first implemented a zero-interest rate policy in order to stimulate an economy experiencing mild, persistent deflation¹. Now, after decades of deflation, prices in Japan are finally rising across the board. We have met with nearly 150 Japanese companies so far this year and the majority of them have raised prices to varying degrees.

On top of that, the yen had depreciated to a near 40-year low, only to see a violent appreciation over the past month. These are significant changes. As market participants re-calibrate their positioning, it is natural to see a period of heightened volatility.

A stronger yen is leading to a re-pricing of companies.

The market assumed that the nearly-40-year-low levels of the yen would be sustained over the short and medium term. This can easily be seen when one looks at earnings expectations for companies over the next few years. While we are not currency experts, this seemed unlikely to us. It seemed clear that the yen/dollar carry trade had become over-stretched and heightened levels of speculative activity were pushing the yen down further.

We have been skeptical, for some time, of the idea that the yen would remain weak over the long term. On any fair value metric (PPP, REER, etc), the yen was objectively undervalued. Investors have been rewarding Japanese multi-nationals that benefitted from the weaker yen, propelling the Japanese stock market higher, even surpassing the previous high-water mark way back in December 1989. However, with the yen’s sharp appreciation over the past month the situation is now reversing. Japanese multi-national companies with higher exposure to foreign currencies are being punished and the more domestically oriented companies are finding favour with investors once again.

Equity speculators are contributing to volatility.

When I was in Japan in 2023 and 2024, attending investing conferences, I met a large number of investors making their first visit to Japan. While some of the rise in the Japanese equity market over the past few years has been underpinned by reforms pushed through by the Tokyo Stock Exchange and government, I also believe speculative capital and “tourist investors” have played a significant role in the appreciation. Unfortunately, these types of investors are often short-term oriented and sell at any sign of trouble, further exacerbating downside volatility.

How should Japanese equity investors position for the future.

Times of high volatility can be nerve wracking, stressful, and confusing, however it is important at these times not to act rashly, but to focus on fundamentals. While we could very well see further market volatility in Japan as the changes of this paradigm shift plays out, we believe that the fundamentals of our holdings in Japanese remain sound and we remain optimistic about their prospects going forward.

At this time in Japan, we are focused on companies with the following characteristics:

Durable competitive advantage
Pricing power to mitigate the impact of higher inflation.
Earnings that are less reliant on, or in some cases completely independent of, currency moves.

Of course, as always, the companies we invest in must be aligned with our three investing tenets, which are: good growth prospects; executive teams that think and act as owners; and companies trading at a significant discount to our estimate of their intrinsic value. We believe companies with these characteristics are highly attractive relative to the broader Japanese market.

In times of heightened volatility, there is a greater opportunity for active managers and value investors to outperform the broader market. During these times we tend to trade more frequently and move more aggressively.

Article by Eric Liu, Portfolio Manager and Senior Investment Analyst, Harris Associates.

Find out more about investing with Harris Associates.

References

¹ https://www.weforum.org/agenda/2024/03/japan-ends-negative-interest-rates-economy-monetary-policy/

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