Japan sets highest rate in 31 years: what now for investors?
This month saw the Bank of Japan (BoJ) raise its main interest rate from 0.75% to 1% – the highest rate since 1995, in response to surging global energy prices due to the Iran war.
While Japan’s inflation rate has sat below its 2% target all year – it was 1.5% in May – a BoJ policy statement suggested a risk of it accelerating above that target, forcing businesses to pass on higher costs. This could lead to “an increase in consumer prices across a wide range of items”.
Widely expected by the market, the rate hike – decided by a vote of seven to one board members – was seen as a landmark step on Japan’s continued path towards ‘normal’ monetary policy, breaking out of a three-decade-long deflationary period.
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Just one dissenter, dovish new recruit Toichiro Asada, voted to hold rates.
Economists and policymakers are described as ‘hawks’ or ‘doves’ depending on their approach to achieving economic stability. Hawks favour price stability and curbing inflation through tighter policy (rate hikes), while doves prefer economic growth and maximising employment through looser policy (rate cuts).
A summary of opinions from the bank’s two-day Monetary Policy Meeting (MPM) on 15-16 June was published by the BoJ last Wednesday (24 June). It doesn’t attribute quotes but cited one member as saying: “Raising the policy interest rate could suppress aggregate demand by curbing firms’ business fixed investment, potentially inducing simultaneous declines in inflation and in production and employment. The Bank should therefore hold the rate steady at this point.”
Most of the opinions warned of mounting price pressures as businesses passed on the rising costs resulting from the weak yen and Middle East conflict.
What does the BoJ’s rate hike mean for Japan’s economy?
As Japan is an importer of natural resources, a weak yen pushes up the cost of imports for its domestic consumers and businesses, in turn fuelling higher inflation.
The yen is currently its weakest against the US dollar since 1986. Macrotrends data shows it was trading around 161.70 on 27 June, with traders braced for the possibility of further government intervention to prop up the currency.
Normally, if the BoJ hikes rates, the yen should get stronger. But according to Alex Hart, investment specialist at fund manager Sumitomo Mitsui DS Asset Management, that’s not happening right now because of the influence of the US.
He explains how people expected the US economy and job market to slow down, which would have led the Federal Reserve to cut rates. But economic revisions have held up – employment data was positive and inflation remains sticky – so a US rate hike may be expected instead.
Hart says this is weighing on the yen in terms of the attractiveness of the ‘carry trade’ (when investors borrow yen cheaply to invest in higher-yielding assets elsewhere).
“At the moment it’s probably more the US and global economy that are the determinants of the yen [as well as] real money demand,” he adds. Higher inflation is also encouraging Japanese consumers to buy more equities – selling yen and buying global assets. That creates additional downward price pressure on the yen.
That said, he doesn’t expect further yen depreciation because the government will likely intervene, which even if it doesn’t work it sends a message to hedge funds that might be looking to short the yen, for example.
Currency intervention is when a country’s authorities – in this case, the BoJ and Ministry of Finance – tap their huge reserves to sell US dollars and buy their domestic currency (yen), strengthening the local currency to help stabilise rising prices.
Many investors are waiting to see how all this affects liquidity, says Scott Gardner, investment strategist at investment platform J.P. Morgan Personal Investing.
A more ‘liquid’ market means consumers and businesses can spend, borrow and invest more easily, fuelling economic activity.
Where are the bright spots for investors in Japan?
Although the BoJ is slowly reducing its quantitative easing (QE) and bond-buying programme, Japanese banks are increasing lending and, in turn, their balance sheets.
“The commercial banks have been producing loads of liquidity, even more yen that has got to find its way into the market,” Gardner adds.
His team at the platform has been overweight Japan since the start of the year in its Fully Managed range, which is constructed using exchange-traded funds (ETFs).
“We like the Japanese economy and see overall economic activity improving, you’ve got the [aforementioned] liquidity picture and also a very pro-growth agenda coming from the Takaichi government,” he says.
Elsewhere, Hart says energy infrastructure-related stocks have performed well, while banks, consumer names and defence look promising.
“Some defence-related names have sold off quite considerably amid global expectations the war is ending. Also heavy aerospace, ships and tanks are being replaced by cheaper drones,” he says.
“But defence spending in Japan has increased to 2% of GDP – potentially moving higher than that. We’re seeing increased spending in other countries as well, also some of those names are now moving into drone technology, so that’s an area I think remains quite a bright spot in terms of its potential.”
Two of Japan’s biggest listed defence contractors are Mitsubishi Heavy Industries (TSE:7011) and Kawasaki Heavy Industries (TSE:7012). Both are listed on the TSE and investing in drone and unmanned aerial vehicle (UAV) technology.
Why invest in Japan?
The other exciting shift in Japan’s investment case, is its move away from a “sleepy giant of mainly industrials and financials” to a technology leader that’s holding its own alongside the rest of Asia.
“Semiconductors are the big thing at the moment, which plays into the index concentration dynamic you also see in the US. Around 21% of the Nikkei 225’s top 10 holdings are in semiconductors,” Gardner adds.
“The AI trade is in full swing across Asia; be it Taiwan, Japan, Korea… that’s one of the reasons why the Nikkei has held up quite well relative to global market conditions.”
While most of the big tech beneficiaries are US-based, he sees the AI trade broadening because those further back in the supply chain who are actually responsible – “the picks and shovels”, as he describes them – are predominantly in Asia.
Hart also points to the tech theme; he says earnings growth is coming largely from data centres, with high levels of capex in electronic components.
Auto giant Toyota (TSE:7203) was Japan’s most valuable listed company by market capitalisation (market cap) for 20 years, holding the top position on the Tokyo Stock Exchange (TSE) before it was displaced by communications company SoftBank (TSE:9984) at the beginning of June.
Now in pole position on the TSE is computer memory manufacturer Kioxia Holdings (TSE:285A).
There is currently a ‘bottleneck’ in NAND flash memory (the type used in memory cards, USB sticks and SSD drives) and Hart says Kioxia (which spun out of Toshiba in 2018) is a pure play on that market.
How should you invest in Japan?
Investing passively in Japan right now is a big play on technology. For investors in index funds understanding the construction of the underlying index is crucial, especially if you’re looking at Japan to add diversification – you might end up doubling down on technology exposure.
The iShares Nikkei 225 UCITS ETF (LON:CNKY), which tracks its namesake index, has an approximately 40% weighting towards tech as of 26 June.
“The Nikkei 225 is share price constructed, which is one of the reasons why Advantest and Tokyo Electron are dominating the Nikkei. In the MSCI, they each make up less than 3%, so it’s a huge discrepancy,” Gardner points out.
It’s possible to invest directly in Japanese shares on some platforms, but this typically comes with restrictions, such as higher minimum investment amounts (Saxo) or having to give instructions over the phone (AJ Bell).
For more diversified exposure to the broader Japanese equity market, actively managed funds can cast their net wider.
Japan has around 4,000 listed companies, while even the TOPIX only has 1,500 names.
“Most of the inefficiency in terms of market pricing – given poor sell-side analyst coverage and so on – is potentially more exploitable with smaller and less-known companies, which active management can find,” says Hart.
Baillie Gifford Japanese is a growth-focused fund that invests in large and medium-sized companies with high and sustainable growth potential, while Man Japan CoreAlpha is another popular choice.
If you prefer closed-ended funds, some specialist investment trusts include J.P. Morgan Japanese Investment Trust (LSE:JFJ), Schroder Japan Trust (LSE:SJG) or AVI Japan Opportunity Trust (LSE:AJOT).
For broad Japanese index exposure, any of the major index fund providers likely have a Japanese equity offering at relatively lower cost, such as iShares Japan Equity Index or Vanguard Japan Stock Index.
Japan makes up around 5-6% of the global stock market (the second-largest regional exposure after the US), so indirect access via any number of global model portfolios or tracker funds will provide some exposure to the region.
