Japan – still on track

Japan became the focus of investors’ attention in the global market turbulence at the beginning of August. Mainly because it was seen by many as one of the main ingredients in the fatal mix that led global markets to retreat. In what was a surprise move for most market participants, the Bank of Japan (BoJ) raised overnight rates from 0.1% to 0.25% on July 31^st. In the next three trading days the yen appreciated while Japan’s stock market fell by 20%. We believe the unwinding of Japanese yen (JPY) carry trades has partly been responsible for this massive move. While domestic investors in the search for higher yields abroad can also move markets, it was probably foreign investors that had been taking advantage of Japan’s low interest rate and borrowing yen cheaply to invest the funds in higher yielding assets in other countries. This might have  caused the bigger turmoil as they often invest on a leveraged basis. Since the market low on August 5th, the Nikkei 225 has not recovered all its losses in local currency terms, but it has done so in dollar terms, thanks to the yen’s big rise in August: Japanese assets should be looked at in conjunction with the yen. The chart shows how different the Nikkei 225’s relative performance versus the MSCI World Index looks when adjusted for currency.  

The gyrations in the market give us an opportunity to update our readers and reiterate our overall positive view on Japan’s economy and stock market, as we set out in our earlier note,^[1] even if, as we explain, there are also some grounds for caution.

The yen’s strong depreciation should be considered when looking at Nikkei’s relative performance

  ^{Sources; Bloomberg Finance L.P., DWS Investment GmbH as of 08/26/24}  

1/ Inflation and reforms fuel the economy

1.1 Inflation after decades of deflation

We just need to look at a very recent data point to get a feeling of what is currently going on in Japan: inflation in August was up 2.6% year on year (y/y), up from 2.2% in July.^[2] And Nikkei reports that minimum wages have been increased by the highest since 2002.^[3]

Economic growth is picking up

Japan's economy is going through a period of transformation and recovery. After a challenging start to 2024, with Q1 growth held back by declining private consumption, the economic outlook has shown signs of improvement. In the second quarter, the growth domestic product (GDP) growth rose to a robust 3.1%, more than the 2% that had been expected. This resurgence was primarily fueled by strong domestic demand, reflecting rising real incomes and household consumption. While consensus growth expectations for 2024 have been cut from 0.8% to 0.05% in the course of the year given that globally manufacturing is recovering slowly, Japan’s growth is still expected to hit 1.2% in 2025.

All about the yen

The yen hit its weakest level against the dollar since 1986 in early July of this year. After having weakened already considerably from 2012 to 2015, another strong wave of depreciation started in 2022, when the U.S. Federals Reserve (Fed) began hiking rates while the BOJ stuck to an ultra-loose monetary policy involving negative central bank interest rates. The weakening yen has helped Japan’s exports. But it has also motivated probably the biggest global carry trade – investors have been borrowing low yielding yen assets in order to invest in higher yielding foreign assets. Carry trades have their dangers which became apparent this summer when the Bank of Japan put interest rates up and the yen gained 12% against the dollar in less than a month. This ultimately provoked the Japanese stock market collapse in early August.

Despite its rally, the yen as of now is still considerably below its average level in 2023, which is good for Japan’s export competitiveness and encourages tourism to Japan. But whether this is sustainable is uncertain. A long-term observation: In the past 50 years, the yen has never deviated so much from its value as calculated by Purchasing Power Parities (PPPs). The Organization for Economic Co-operation and Development (OECD) calculates that the Yen is currently 40%  cheaper than PPPs would suggest. This contrasts with the period from 1985 to 2013 when the Yen was more expensive than PPPs suggested.

We forecast the yen to appreciate mildly 

We forecast that the yen will be range bound with a slight tendency to appreciate over the coming 12 months. It may be volatile, however, and vulnerable to any changes in a few key factors: above all, the U.S. Fed rate cut cycle and the commitment of the BoJ to its rate hike plans even if economic (or inflation) dynamics weaken somewhat. For the time being, we believe that the carry trade remains very much on, especially among Japanese investors looking for higher yields.

Real wage growth and price inflation are finally back

The recent volatility in financial markets masks improving economic fundamentals. The spring wage negotiations between unions and business are pushing up wages further, bolstering domestic demand. In June, real wages have risen for the first time since mid-2021. Our GDP growth forecasts remain cautiously optimistic, with growth likely to pick up to 1.2% in 2025 after a flat 2024 provided consumer spending remains firm and economic reforms continue.

Inflation dynamics in Japan are also evolving. After inflation was initially boosted by strongly rising import costs (as everywhere in the world), the process of hiking prices now is on a more self-sustaining footing as the initial price hikes have fostered long-awaited wage hikes which in turn led to another round of price increases. We expect inflation to moderate but remain above the 1% threshold. For 2024 headline inflation is projected at 2.5%, eventually easing to 2.0% in 2025. This persistent inflation, although quite modest, represents a recovery from Japan’s deflationary past and provides a favorable backdrop for the BoJ to continue with its cautious policy normalization. For a more in-depth analysis of Japan growth story, please see our special “Reflation in Japan” (https://www.dws.com/insights/cio-view/macro/cio-special-01102024/).

Central bank wary of stifling inflation – we expect moderate rises in bond yields

The Bank of Japan plays a pivotal role in Japan’s economy. In only its second rate hike since 2007 the BoJ increased its policy rate to 0.25% on July 31 this year. Though this decision triggered a significant market reaction, with a sharp selloff in equities and a flight to Japanese government bonds (JGBs), it underscores the central bank's cautious approach to monetary normalization. But an intervention seemed inevitable in light of the dynamic yen depreciation. BoJ Governor Kazuo Ueda emphasized that further rate hikes would be data-dependent, allowing for flexibility in policy adjustments so as not to jeopardize the slowly re-emerging inflationary mindset that the central bank and the government have aimed to foster. Sticking to the ultra-expensive monetary policy was no option, as the costs for the financial system and consumers’ and corporates’ behavior were too high.  We expect a further rate hike in January and another in mid-2025, based on the BoJ’s view that the underlying domestic inflation dynamics are strong enough, which in turn requires another round of supporting (2025) spring wage negotiations. The rate hikes will, we believe, lead to slightly higher bond yields along the curve on a 12-month horizon: we expect 2-year JGB yields to hit 0.7% and 10year yields 1.4% in September 2025.

Japan’s world-beating debt leaves little room for error

Japan’s huge public debt pile is one reason to be cautious about the country’s prospects. It has the highest debt to GDP ratio (both gross and net) of all developed countries. With an average duration of 8 years, Japan needs to refinance a large amount of JGBs each year: around 30% of GDP, much higher than roughly 20% in the U.S. and Italy. To stabilize or even reduce debt ratios, it is crucial that Japan manages to grow strongly in nominal terms in coming years. In addition, fiscal policy needs to become more frugal.