Fed Rate Hikes May Benefit Japanese Stocks

Key Points

  • Japanese stocks got an unexpected boost after the U.S. presidential election as a surging dollar pushed the yen lower.
  • With the Bank of Japan targeting 0% yields on Japanese government bonds and the U.S. Federal Reserve on course to raise interest rates this year, the yen could fall further, boosting Japanese stocks.
  • When the yen is weak, investors could consider using currency-hedged exchange-traded funds to try and benefit from gains in Japanese stocks.

Japanese stocks got a boost from an unlikely source last year: the U.S. presidential election. Donald Trump’s win in November sent the dollar surging, as market expectations that he would cut taxes and boost spending raised the prospect of higher interest rates. In response, the yen tumbled. And the Japanese stock market actually outperformed markets in the U.S. and other developed countries, with Japan's Nikkei 225 Index delivering higher returns than both the S&P 500® Index and the MSCI EAFE Index in the last two months of 2016.1

While Japanese stocks paused in early 2017, there are reasons to believe gains could continue.

Japanese stocks like a weaker yen

From Nov. 7 to Dec. 31, the yen fell nearly 12% against the U.S. dollar. Japanese stocks rose in turn. This has a lot to do with Japanese companies’ heavy reliance on exports. When the yen weakens, Japanese exports start to look cheaper overseas.

In fact, Japanese stocks have tracked the yen’s level against the dollar pretty closely in recent years. As you can see in the chart below, they fell when the yen strengthened and rose when it weakened. In the chart, a rising line for the yen means the dollar buys more of the Japanese currency (i.e., the yen has weakened against the dollar).

Japanese stocks correlated with the dollar/yen

Japanese stocks correlated with the dollar/yen

Source: FactSet, Nikkei Stock Exchange, WM/Reuters, as of 3/3/2017. Past performance is no guarantee of future results.

Why did the yen fall?

That Japanese stocks would rise after Trump’s victory might seem counter-intuitive. After all, he has seemed hostile to trade at times and pulled the U.S. out of the Trans-Pacific Partnership trade deal, which would have lowered trade barriers between the U.S. and Japan, among other countries.

However, some of his other policy proposals raised the prospect of increased fiscal spending in the U.S., which could boost inflation and pave the way for higher interest rates. Such expectations caused Treasury yields to rise sharply after the U.S. election.

Now compare that with what’s happening in Japan. In September, the Bank of Japan (BOJ) started targeting a 0% yield on the 10-year Japanese government bond (this involved a change to its asset-purchase program to target “yield curve control”). When Japanese yields are effectively anchored at 0% and U.S. Treasury yields are rising, the U.S. dollar starts to look more attractive. As a result, the dollar rises and the yen falls. 

Japanese stocks have tracked U.S. yields

Japanese stocks have tracked U.S. yields

Source: FactSet, as of 3/3/2017.

How long will this divergence last? That depends in part on the Japanese economy. After struggling with a bout of deflation, Japanese core inflation excluding fresh food just returned to positive territory in January for the first time since 2015. If this continues, the BOJ might have to consider easing back on its support for the economy. However, the central bank wants to overshoot its 2% inflation target in a bid to get people accustomed to the idea of rising prices again. This could keep changes by the BOJ at bay for some time.

Back in the U.S., the Federal Reserve looks set to take the opposite course and could raise rates several times this year. If that happens, the spread between 10-year U.S. Treasuries and Japanese government bonds could widen even further, weakening the yen and likely boosting Japanese stocks.

Yen weakness could boost corporate profits

Japanese companies derive a high percentage of their earnings from overseas, meaning that yen weakness could boost profits. Analysis by Evercore ISI indicates that every 1% drop in the yen against the dollar lifts overall corporate profits by 0.7%. As you can see in the chart below, a stronger yen weighed on corporate profit growth in the first half of 2016, but the situation improved as the yen weakened after the November election.

Japanese profits benefit when yen weakens

Japanese profits benefit when yen weakens

Source: FactSet, Japanese Ministry of Finance, as of 3/3/2017.

What does this mean for investors?

We believe the yen is likely to weaken further relative to the U.S. dollar, which could continue to drive Japanese stocks higher. However, it’s important to note that investors using U.S. dollars should consider hedging their positions. After all, a weaker yen could lead to lower returns when converted back into U.S. dollars. We suggest using currency-hedged exchange-traded funds.

That said, currency hedging can help performance in the short term, but if you’re investing for the longer term, hedging could mean less volatility but may not help returns. See “Currency Hedging: 5 Things You Need to Know” for more.

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