Changing economic circumstances could alter the market impacts of currency weakness explain experts Masaki Taketsume, George Brown and Robbie Boukhoufane.
It’s a been a difficult first third of 2022 for markets generally, which is perhaps unsurprising given the many sources of uncertainty and discord in the world.
A very sharp depreciation in the value of the yen, however, will have potentially made a tough period all the more challenging for overseas investors in Japanese assets. They might have felt the full force of the fall in the yen had they not protected themselves against currency volatility.
On a more encouraging note, in “local currency terms” (see table, below), Japanese equities have been relatively resilient. Local currency terms give a picture of how the underlying market has performed, as it strips out the impact of exchange rate moves that non-yen investors feel.
This resilience versus some other developed markets perhaps partly reflects hopes that a lower yen will boost Japan’s export-heavy economy.
All the same, experts caution against drawing hard and fast conclusions around currency impacts, especially in light of some changed economic circumstances within Japan.
The return of inflation following a two-decade absence is causing some disquiet among consumers accustomed to falling prices or deflation. Its reappearance also underlines some economic complexities at play, not least the country’s increased energy dependency since the Fukushima nuclear disaster in 2011.
George Brown, economist, said: “A weak yen has historically been cheered by Japan’s industrialised economy. But years of offshoring and increased energy dependency has meant its 13% fall this year has been greeted with more concern than celebration.”
“Offshoring” refers to the process whereby many of Japan’s manufacturers have moved their factories to lower-cost countries. Yen weakness carries less opportunity for the economy as a result as the benefits to international competitiveness have been diminished.
A currency decline, however, is potentially more an inflationary threat than in the past. This is largely as a result of the country’s increased dependency on imported energy following the Fukushima accident, with many nuclear plants in the process of being decommissioned.
Sharply higher energy prices following Russia’s invasion of Ukraine have brought these risks into sharp relief.
Robbie Boukhoufane, fixed income and currency portfolio manager, said: “Japan is vulnerable to the sharp rise in commodities, with imports continuing to surge – driven by soaring energy prices – while export gains have also slowed.”
Inflation is not expected to rise to anything like the rates currently seen in Western developed markets. While consumer price inflation is forecast to jump to a level close to the Bank of Japan’s (BoJ) 2% target in the next couple of months, this is by no means a large spike in absolute terms.
But even moderate rates of price growth could prove challenging for some companies and sectors, not least given likely consumer resistance to rising prices.
Experienced investors are currently focused on finding those businesses best able to increase prices of their end product in order to offset any impact on profits.
They have noticed that companies are beginning to test their so-called “pricing power” as their own input, or “producer prices” continue to rise. These prices having already been on an upward trajectory for some time as Japan has also been grappling with Covid-related disruptions.
Masaki Taketsume, Japan fund manager, said: “We have recently seen some anecdotal evidence of companies looking to pass on these increases to end-product prices.
“However, their ability to fully defend margins by passing on cost increases is still debateable as domestic consumers remain very price sensitive after two decades of deflation.
“Some particular sectors may struggle in this environment, such as retailers who are exposed to the end consumer, and transportation firms, where fuel is a large component of their costs.”
That said, Taketsume, remains confident in the ability of Japanese companies on the whole to grow profits this year.
“Overall, we are comfortable that aggregate corporate profits for the listed sector can continue to grow, potentially hitting further new highs into fiscal 2022.”
Inflation is not expected to become the threat to price stability seen in the West, where concerns are prompting aggressive monetary policy “tightening” by central banks.
Certainly, experts remind us that the imminent ascent of annual consumer price inflation close to 2% is partly technical in nature, and not just the result of yen weakness.
For instance, politically driven cuts to mobile telecom charges in prior years had a one-off effect of reducing inflation, which is now dropping out of yearly calculations.
“How long a level close to the Bank of Japan’s 2% target is sustained, and the ultimate peak for inflation in this cycle, is especially dependent on energy prices, but we still see structural reasons restricting any larger spike in inflation in Japan,” Taketsume said.
Economist Brown agrees. “Given underlying economic conditions, there is little sign inflation will take off this year or next.” Conversely, however, he does not foresee any meaningful change in monetary policy which may cause a reversal in the yen and relieve some of the inflationary pressures.
Japan’s monetary policies seem set to continue supressing bond yields. This is diminishing the attractiveness of Japanese government bonds, or JGBs (and demand for the yen) versus government bonds in other major developed economies.
In the US, for instance, the dollar has appreciated as Treasury yields have risen in response to tighter policy from the US Federal Reserve (Fed).
Japan’s ruling LDP party is mindful of consumer disquiet at rising prices denting its prospects for July’s Upper House elections, according to Brown, but any intervention is likely to be ineffectual.
“There is speculation Tokyo may use its foreign exchange reserves to try to support the yen for the first time since 1998,” Brown said.
“However, it will struggle to make much headway so long as the Bank of Japan breaks ranks with its global peers by maintaining its ultra-accommodative policy.”
In April the BoJ doubled down on its own choice of “unconventional” monetary policies (in its case yield curve control) to be achieved by unlimited purchases of 10-year JGBs.
All major central banks deployed unconventional policies in the wake of the global financial crisis when conventional ones such as cutting interest rates were exhausted. They then reactivated these programmes in response to pandemic-related shutdowns.
Most have either ended these schemes, or are poised to reverse them in the case of the Fed in a process of monetary “normalisation”.
Central banks have accumulated large quantities of government bonds under quantitative easing (QE) programmes – the purchase of such bonds was used to inject money directly into the financial system. These stocks on their balance sheets now look set to be gradually run down, to be sold back into the market.
The direction of travel in the West, however, stands in sharp contrast to the BoJ’s intentions for adding more JGBs to its balance sheet.
This situation seems unlikely to change in the near term, explains Boukhoufane.
“Although there have been some concerns about the speed of the yen’s recent decline, policymakers are less concerned about inflationary pressure than in other countries,” he said.
All in all, a more nuanced picture is perhaps emerging which might complicate the historical trend for Japanese equities to perform well when the yen is weak (see chart, below).
However, overall profits of listed Japanese companies are still expected to remain resilient during this turbulent period, while the skilful selection of individual investments might be in demand.
Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amount originally invested.
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