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A weaker yen has helped propel Japanese stocks to record highs this year, but overseas investors see investment opportunities in Japanese stocks even as the yen starts to strengthen. For much of this year, a weaker yen was the main argument for Japanese stocks among foreign investors who looked at the stock market. It boosted the performance of companies such as Toyota Motor, for example. For investors holding Japanese assets denominated in yen, a weaker yen led to an increase in the value of their earnings. And for a long time, a weaker yen seemed like a safe trade. From January 2021 to June 2024, the yen depreciated 55% against the dollar, breaking the 161 mark in June this year, the lowest level since 1986. However, the Bank of Japan’s decision to raise interest rates in late July – thereby narrowing the interest rate gap with the United States – caused the yen to finally start to strengthen against the dollar. Meanwhile, the Nikkei 225 index fell more than 12% on August 5, the biggest single-day drop since “Black Monday” in 1987. The yen last traded at around 144 against the dollar. JPY= YTD mountain yen-dollar exchange rate in 2024 “Yes, there is volatility (now), but we are not hiding from it. In fact, we are embracing it and using the liquidity that the market gives us to expand positions,” said Julian McManus, portfolio manager at Janus Henderson. McManus is not the only one to increase exposure to the Japanese market after the early August sell-off. In the same week, inflows into Japanese equity funds hit their third-highest level of the year, according to EPFR. Impact of a stronger yen on earnings Jefferies said the downside impact of a stronger yen on Japanese corporate earnings would be limited, assuming global economic growth remains stable. Shrikant Kale, a strategist at Jefferies, said that since 1995, the yen has appreciated by an average of 25% against the dollar in the last four periods of “decisive” yen strength. With that in mind, Kale estimates that a yen appreciation to around 120 against the dollar would result in a 10% drop in corporate earnings in a soft landing scenario. He added that in this scenario, the market would correct 9% to 14% in yen terms, but would actually rise 5% to 9% in dollar terms. Bank of America also believes that while a stronger yen poses a risk to corporate earnings, the yen is trading around 156 to the dollar from April to June this year, which is still enough savings. McManus of Janus Henderson agreed that a stronger yen would not be a concern for corporate earnings. He pointed out that most companies have budgeted for the full year based on 145 yen to the dollar, not higher. So even if the yen falls sharply from its 2024 highs, the annual average rate will still be lower than the average rate assumed by companies. “In Japan, we see higher-than-expected earnings growth of 10-11%, supported by nominal reflation and corporate reforms, and we do not think the recent volatility will disrupt this growth,” wrote Daniel Blake, a strategist at Morgan Stanley, in an Aug. 20 report. Helping dollar-denominated investors The big move in the yen will benefit foreign investors. Earlier this year, even as the Nikkei 225 climbed to record levels, a weaker yen hurt dollar-denominated stock prices. Before the yen began to strengthen, “Japanese investors could benefit because their lives and portfolios are denominated in yen. But for foreign investors, it’s more challenging because you can’t convert the value of Japanese stocks in yen to the value of Japanese stocks in dollars,” said Peter Perkins, partner at Macro Research Board Partners. So as the Japanese market continues to rebound, a stronger yen will help overseas investors profit from the Japanese market. The Nikkei 225 has recovered from the Aug. 5 sell-off and is up nearly 15% so far this year. .N225 YTD Peak The historical trend of the Nikkei 225 supports the case for Japan to outperform during periods of yen strength, Jefferies said. In the past four cycles of yen strength, the MSCI Japan Index fell more than 7% in yen terms but rose 24% in dollar terms, even outperforming the MSCI All Country World Index by 24%, according to the firm. “This suggests that global investors should be overweight Japan if the cycle moves toward a period of sustained yen strength,” Jefferies said. The U.S. bank predicts a “full recovery” in stocks by late September or October and estimates the market will trade near March highs by the end of the year. Perkins noted that despite the yen’s elevated volatility, the currency remains relatively cheap. He added that before the Fed began raising rates, the yen was trading at 103 to the dollar and the market saw a fair value of 120 for the yen. Perkins said investors should gradually add exposure now rather than wait for the yen to stabilize further. “Certainly, the drop from 163 to 147 is a reminder that things can change relatively quickly. … Gradually adding exposure and taking advantage of what we think is the right thing to do is,” he said. To be sure, an external shock or threat to Japan’s economy or global growth could threaten the outlook, Perkins added. “It could happen, but we don’t see any reason to believe it will,” he said. “It’s an element of uncertainty, and you can’t run an investment strategy with constant worry about uncertainty.”
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