The Zen of Yen

TUE 29 MAR 2022

Following the balance sheet recession Japan has experienced a long (perpetual) phase of near zero interest rates. The period also coincided with a fairly robust phase of global growth prior to the 2008 crisis and higher yields in other markets (especially in EM and commodity linked countries). As a result, the Japanese yen was often the funding currency weapon of choice for carry trades. A correlated belief that the condition would persist, contributed to a large build up in levered positions prior to the Great Financial Crisis and the rapid unwind that followed. As we have noted in the past, long phases of stability eventually lead to an episode of instability once policy (such as a peg or yield curve control) breaks (and they always break).


After a phase of relative stability in recent years, the Japanese yen has depreciated almost 8% over the past three weeks relative to the US dollar. Perhaps not surprisingly, yen weakness has coincided with the rapid shift in the prevailing bias on US short term interest rate expectations and Treasury yields. As we have noted over the past month, the conflict in Ukraine amplified the supply shock, trend in commodity prices, inflation and interest rates that were already underway this year. As a large net importer of energy and commodities, Japan has clearly been exposed by the episode, both in terms of its external position, inflation and the capacity of policy to respond to the crisis.

For markets, the key big picture point is that growth and interest rate differentials between Japan and the rest of the word have widened rapidly over the past few weeks, consistent with weakness in the yen, particularly relative to commodity and other carry currencies (chart 1). Looking further out, the key question is if or when the Bank of Japan is incapable of maintaining yield curve control. The (obvious) constraint is if or when inflation becomes unhinged.


For now, around 90% of Japan’s debt is still held domestically and the country still holds a large amount of net foreign assets. The greater challenge will be if or when Japan requires foreign capital or as we noted above if inflation expectations become unanchored. Japan’s domestic debt is only sustainable while interest rates remain low.

The good news is that yen weakness has tended to be positive for Japanese equities (chart 2). While the relationship is often overstated, Japan has the highest operating leverage of any major market to global growth (beta of EPS to global industrial production) given the composition of the index and therefore tends to benefit from currency weakness. In addition, corporate leverage (ironically) is very low; Japanese listed companies (in aggregate) have net cash on balance sheet.

The market trades at a 20% discount to global and equities and a 32% discount to the United States. Over the past decade there has also been a trend improvement in return on equity (profitability) and convergence with the rest of the world. From a tactical perspective, Japan’s high operating leverage to global growth also suggests that the market is vulnerable to a growth scare later this year. On the positive side, material undervaluation of the yen is a helpful buffer.


The final point to note is that the scope for alpha in Japan is high given analyst coverage is extremely low. The leading 3,700 companies have on average only seven analysts covering them (as at 2021). Despite it being the second-largest single country equity market in the world, 40% of Japanese companies have no analyst coverage at all. From a behavioural perspective, that suggests an element of revulsion, capitulation in beliefs or that many investors have simply given up on the market.

 

In conclusion, we continue to hold a position in Japanese equities (with a quality bias). Currency weakness is helpful in the near term, but clearly could be detrimental if it became truly episodic (at 150 or 200 on the USDJPY).