Japan's stock market had an impressive Q1, with the Nikkei 225 Index soaring past the 41,000 markHowever, a noticeable downturn in Q2 led to significant declines in stock returns, placing Japan among the lower-performing equity markets globallyAn array of factors contributed to this shift, notably the strength of the U.Sdollar, which has created a tumultuous environment across Asian currenciesAs of June 26, the dollar began trading at alarming rates, exceeding 7.3 yuan for the offshore Chinese currency and causing the Japanese yen to plummet past the 160 mark against the dollar—a 34-year low.

The near-term outlook for the yen appears bleak, as the Bank of Japan (BOJ) is seemingly reluctant to employ aggressive monetary interventionsThis past March, the BOJ embarked on a rate hike; however, by late April, the yen had already breached the significant threshold against the dollar

Market interventions temporarily pushed the dollar/yen rate down to around 150, but persistent undervaluation and external pressures have made it difficult for the yen to maintain any stabilityA crucial element driving these developments has been Japan's slower-than-expected economic recovery, compelling market sentiment to sour considerablyThe timeline for the BOJ's anticipated first rate hike has since shifted from July to October, leading many to speculate that the yen may only stabilize around that time.

The performance of the Japanese stock market cannot be overlookedFollowing a robust Q1, where the Nikkei 225 saw impressive gains, the second quarter proved less favorableThe Topix index remains relatively stagnant, hovering between the 2700 and 2800 points, while the Nikkei 225 now fluctuates within the 38,000 to 39,000 range

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While we maintain a positive outlook on the medium-term prospects for Japanese equities—believing that the end of deflation in China coupled with improvements in corporate governance could invigorate the market—short-term results have been disappointing, with fundamentals ultimately guiding investor sentiment.

The Yen’s Continuation Below 160

The bullish breakout of the dollar index has exacerbated pressures on the Asian markets, with recent weeks experiencing particularly heightened turmoilThe dollar's strength in 2023 has surprised many, including economists; every time it appears to be reaching a trough, it finds a way to rebound strongly—with recent weeks exemplifying this pattern.

Weakness among major Asian currencies, coupled with uncertainties stemming from the French election, has undermined the euro, allowing the dollar index to break away from its downward trajectory since November 2022. The ongoing lack of upward support throughout May and June suggests that if current trends continue, we might see the dollar index breezing past the resistance level of 108.

Looking ahead, we believe that significant recovery for the yen against the dollar is unlikely before Q4, even with the BOJ's ample financial resources

If any intervention occurs, we anticipate that it will only come in response to severe yen depreciation, not as a measure aimed at reversing the current trendTo push against that current could waste the BOJ’s ammunition.

Reflecting back to late April, the BOJ intervened, resulting in a temporary drop in the dollar/yen exchange from a post-meeting peak of 160 down to just below 152. But since the negative underlying fundamentals of the Japanese economy have not improved as anticipated, and seeing that the disparity between U.Sand Japanese interest rates persists at high levels, traders continue to exhibit a lack of motivation to invest in yen assets, which, regrettably, has led to its sustained declineThe yen's recent trajectories have begun to correlate closely with the renminbi, with the yen following downward with even more pronounced declines.

In recent years, the diminishing interest rates in China have positioned the renminbi as a funding currency, while the yen, mired in a long-term zero-rate policy, has long served a similar role

This correlation signals that understanding the dollar/yen trajectory may now necessitate keen observation of the dollar/offshore yuan ratesEvidence suggests that recent drivers supporting the dollar's rise have stemmed more from shifts in the renminbi than in the yen.

Heading into Q4, a significant yen depreciation against the renminbi remains a risk, further complicated by the Chinese central bank's ongoing measures to guide currency stabilityOver the past four years, the offshore yuan has surged by more than 51% against the yen, with nearly 12% occurring in 2024 aloneAs one of the world’s manufacturing keystones, Japan’s cost competitiveness in international markets, especially concerning Chinese goods, heightens the pressures on China's economy during periods of softened demand.

The trajectory of the Federal Reserve’s potential rate cuts will be vital for future developments

Recent economic outlooks from June reflect increased inflation forecasts for 2023 and 2024, with expectations pointing toward a single cut this year, while markets anticipate twoThere’s a 61% probability of a 25-basis-point cut in September, yet opinions remain divided—especially as Fed official Michelle Bowman declared her stance against any rate reductions for this year.

That said, a potential scenario unfolding in Q4 where the Fed lowers rates in tandem with the BOJ likely enacting rate increases could shift the yen’s trajectory, maintaining BOJ’s vigilance against rapid depreciation.

Transitioning from Overweight to Neutral on Japanese Stocks

Beyond the yen's unexpected downturn, the Japanese economic recovery has not met the expectations of investors looking to lock in gains from the stock market

As a result, we are rating Japanese equities from an overweight to a neutral position.

Currently, the weakening yen no longer serves as an asset for the Japanese stock marketAlthough a depreciating yen can stimulate exports, particularly for large corporations in the automotive, machinery, and technology sectors, the broader spectrum of worries regarding excessive depreciation loomsMinutes recently released from the BOJ meetings indicated market concerns about imported inflation, potentially driving up costs for small and medium enterprises, inhibiting competition and capital investment, while simultaneously denting consumer purchasing power.

Previously, analysts noted conspicuous differences compared to 2022’s passive import-driven inflation

With the recent decrease in raw material costs, firms were expected to continue raising prices and households appeared willing to oblige, leading to anticipations of widespread wage increasesYet, after decades of deflationary influence, investor sentiment in Japan remains quite cautious, and substantial price increases without fundamental earnings backing aren't being readily embraced.

Indeed, despite rising prices, the expected consumer rebound has not materialized, contributing to Japan’s GDP sliding back into negative territoryRecent adjustments to economic data showed that GDP contracted by 1.8% year-on-year, dipping from a previous estimate of a 2.0% reduction and settling well below the projected 1.5% dropThis trend of negative growth, occurring after a mild recovery the previous quarter, reflects growing strain on expenses, as rising fuel and food costs attributed to the yen’s decline have negatively impacted household expenditure

In May, the sentiment metrics for Japan's service sector plummeted to the lowest point in two years.

Moreover, estimates point to the resilience of Japanese equities in periods of rising U.Sinterest rates, although they not benefitting correspondingly when rates decreaseThis reflects the phenomenon where the yen could appreciate simultaneously, while the strong value characteristics of Japanese stocks hinder their performance in such environmentsThis notably occurred during the heightened interest rates of 2021, and those peak periods of October to December 2022 and November to December 2023, clearly illustrating lagging performance since the declines commenced in late April.

Furthermore, the long-term trajectory of Japanese domestic interest rates could suppress risk appetite

The yield on 10-year Japanese government bonds (JGB) reached a peak of 1.1% on May 30—the highest since July 2011. The BOJ is set to detail its plans for tapering JGB purchases at the next monetary policy meeting in JulyThe anticipated reductions may begin as early as August, and the Bank Governor has stated that any scaling back will be “meaningful.” We believe that emerging positive data concerning wages and service prices in small to medium enterprises could accumulate, inducing a scenario where bond yields rise back toward 1.25% by 2024 and potentially reach 1.8% by 2025.

From an equity perspective, if rate hikes are grounded in robust domestic economic conditions along with an effective wage-price cycle, then such increases could be absorbed by the market; however, this remains to be seen.

Overall, we hold an optimistic long-term view for Japan's stock market, primarily due to the expected end of the domestic deflationary trends alongside improvements in corporate governance