Japanese financial markets are undergoing a long-awaited reflation trade. There’s just one missing factor: the Japanese investor.
Foreign buyers have been in the driving seat of a rally that has driven Tokyo shares to record highs last month and coincided with an appreciation of the yen. They have also been major sellers of Japanese government debt, causing yields on 30-year bonds to reach all-time peaks.
“Global investors have been a major driver of the rise in Japanese stocks,” said Nicholas Smith, a strategist at CLSA in Tokyo. “There is little sign of domestic investors chasing,” after a rally in the Topix from lows reached in April, he said, which has pushed the index up 34.2%.
As supportive government policies and corporate reforms help Japan to ignite economic growth after almost three decades of lacklustre activity, the Bank of Japan raised interest rates this year for the first time since before the 2008 global financial crisis and has sold down its vast holdings of government bonds.
That has stoked an asset rotation from bonds into equities, boosting beat-up industrials at the expense of flashier growth stocks, while favouring shorter-dated bonds to the longer-dated end of the yield curve.
Some analysts believe the rally in stocks could have further to run if Japanese retail investors resume buying, after pulling out some $23 billion so far this year.
“Retail sentiment is finally back in the positive since last week after hitting an extremely bearish level,” analysts from Bernstein said in a research report.
Attributing retail investors’ caution to uncertainty over how U.S. tariffs would affect Japan’s economy and market volatility, they said the combination of a recovery in earnings, strong foreign investor confidence and return of retail flow “looks quite supportive for markets.”
Foreign flows into equities this year are the strongest of the past decade, and on track to mark the highest since the Abenomics-inspired influx of 2013.
“Foreigners aren’t the only entities buying though: corporates, through share buybacks, were even larger,” said CLSA’s Smith. “That’s very exciting, because corporates are awash with cash and could afford to buy a whole lot more.”
Despite the outsized moves in stocks and bonds, the yen has proven relatively stable, remaining stubbornly within a 140-160 trading range for the past two years rather than strengthening on the prospects of stronger growth, or from a rush of investor fund flows lured by higher bond yields or equity returns.
“The big story is the lack of repatriation flows,” said Brad Setser of the Council on Foreign Relations. Setser attributes the absence to Japanese institutional portfolios that invested heavily in U.S. Treasury markets prior to COVID-19 now being effectively under water after the Fed’s increases in interest rates.
Put simply, Japanese capital is staying overseas rather than coming home to chase the gains.
Analysts and traders are watching closely whether that will change as the Japanese markets spring into action.
Here are some charts that show Japan’s asset rotation.
1/ Asset class rotation
Investors betting on stronger economic growth are pulling cash from fixed income and piling into stocks instead. The Nikkei 225 and Topix indexes have reached all-time highs.
/2 Value beats growth
Mirroring reflation trades in other countries, Japanese value stocks have outperformed faster-growing companies. Often, quantitative investors interpret this trend as an indication of economic growth becoming more diffused throughout the economy.
/3 Carry trades
Foreign buyers of JGBs are able to generate a substantial pickup over equivalent-dated U.S. debt. A five-year Treasury bond generates a yield of just 3.86%, compared to a Japanese government bond of the same maturity swapped into U.S. dollars which returns a 5% yield. This bond market alchemy is only possible because of the large interest rate gap differential between the Federal Reserve and the Bank of Japan.
/4 Yen hedging costs
But that boost only goes in one direction. Japanese investors find it more expensive to invest in the U.S. on a currency-hedged basis because of the Bank of Japan’s relatively low interest rates.
/5 Japan’s overseas riches
Japan lost its crown as the world’s top creditor earlier this year to Germany, yet a sizeable quantity of its financial assets are held outside Japan and could be sold and brought back home.
Source: Reuters
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