Butterfly Wings Flap in Japan

Butterfly Wings Flap in Japan

Export to PDF

By David Ruff, Portfolio Manager

According to Mathematics’ chaos theory, small random changes in initial conditions can lead to unpredictable, disproportionately large-scale outcomes. Explained metaphorically by the “butterfly effect”, the phenomenon starts with a miniscule wing flap in the Amazon, setting off a chain of events resulting in a Midwest tornado a few weeks later. Such interconnectedness, with small changes having far-reaching consequences, applies not only to atmospheric conditions, but also equity markets. Evidently, a butterfly flapped its wings in Japan in late July and an equity storm ensued. The feared hurricane, however, turned out to be a temporary squall, and importantly, we believe the fundamentals for Japanese equity investment remains positive.

In the first two days of August, US and global equities dropped over eight percent, and Japan, measured by the TOPIX fell, incredibly, by over 20 percent. Wondering how a seemingly innocuous, modest interest rate hike by the Bank of Japan on July 31^st could set off a global equity downdraft of such magnitude, many investors, understandably, remain shaken and uneasy about the global equity market outlook in general, and Japanese equities, in particular.

At the risk of providing ad nauseam information, considering the voluminous spilled ink describing the situation, we think the following provides insight into how the market turmoil ensued. By way of review, the carry trade, its sudden unwind, combined with US economic reports caused the market panic. As you all, no doubt, know by now, the carry trade entails borrowing low-interest-rate yen, and investing at a higher interest rate in bonds denoted in other currencies. Participants profit from the rate spread, assuming the yen stays stable or weakens relative to the currency of the other investment to avoid paying back the loan with a weaker currency. Utilized for close to two decades by an extensive number of mainly international players like hedge funds, pension funds, investment banks, as well as Japan export counterparties, the net short yen position became massive. Moreover, institutional investors, and more recently, Japanese retail investors, also borrowed yen to establish positions in other assets, mainly equities or equity derivatives. With the Bank of Japan not hiking interest rates for 17 years until March of this year, and with little reaction by the yen at that time, investors became oblivious to the trade’s risks. However, when the BOJ again hiked rates on July 31st, the yen significantly strengthened. The timing proved unfortunate.

The graph below shows that while Japan and Europe equities remained relatively flat in the last two weeks of July, US equity markets already started to correct, set off by disappointing big tech earnings results. With the US equity market already on its heels at the end of July, combined with a weak end-of-month US employment report, investors feared a US recession and lower US interest rates. Piling on, the BOJ hiked rates, putting additional upward pressure on the yen. Unsurprisingly, this rapid yen reversal, caught most off guard, and the carry trade became a significant carry loss. Those with leveraged positions, especially the newer players to the game, needed to urgently liquidate to meet margin calls. Paper losses stoked fear, causing more sell orders, adding to the carnage. With everybody selling simultaneously, prices plunged. Like a storm that blows itself out, however, such conditions cannot last. The selling pressure inevitably abates, and value hunters purchase the mispriced equities. As of this writing most equity markets, including Japan, have substantially or completely recovered from their early month declines, but have not yet moved above their mid-July highs.

This volatility highlights the global financial markets’ interconnectedness as well as how economic data can drive short-term capital flows. While the recent market volatility may be alarming, we hope you take solace in understanding the financial dynamics that caused the short-term distortion. Of course, global equity markets will continue to suffer future gyrations. It goes with the territory, but patient investors understand equities represent an asset class best used for longer-term time horizons.

^{Source: Bloomberg}

Knowing that the recent Japanese equity performance slide had nothing to do with Japan corporate fundamentals, we focus on Japan’s future economic conditions. In this regard, we expect a conducive climate for successful equity investing. Longer-term, earnings determine equity prices, and Japan’s corporate profits show good momentum. The following table highlights Japan’s recent corporate earnings growth relative to other major regions and select countries. Outside of China, which is lapping depressed 2023 earnings, Japan’s growth and positive earnings surprise scores well, as does the US. Notably, India and Latin America score poorly on this earnings growth metric.

^{Source: Bloomberg}

Importantly, Japan can lift interest rates, due to the country finally slaying the deflationary dragon, posting positive inflation now for more than two years. Not just a cyclical improvement, we believe this represents a fundamental game changer for the country. With deflation, consumers and businesses postponed purchases as long as possible, waiting for lower prices, and hoarded cash. Obviously, with the return of inflation these behaviors change. Reflation should release the country’s excess savings, now at a staggering $9 trillion, or 54% of assets. Consumer spending should accelerate, and indeed, the last quarterly GDP print, showing growth at an annualized rate of 3.1%, reflects consumption of automobiles, appliances, and other durables rising by 8.1%. Corporates, also flush with cash, now willingly raise wages and more aggressively spend on productivity enhancing equipment as well as labor-saving software. Additionally, the government, effective January 2024, meaningfully contributed to the positive equity investing outlook by tripling the allowed annual contribution for Nippon Individual Savings Accounts (NISA) and made dividends and capital gains permanently exempt from taxes. As it did in the US and Australia, this type of retirement plan legislation change encourages households to increasingly participate in equity markets. Despite the positive fundamentals, Japanese equities remain extraordinarily cheap, trading at just 1.3 times book value, just 26% of the S&P 500 level. With Japanese companies exhibiting better corporate governance and delivering better profitability we look for this valuation gap to shrink in the coming years. Accordingly, Japan ranks high in our International and Global portfolio allocations.

A butterfly wing flap causes a storm? Maybe, with the right conditions, but most assuredly, after the storm, comes the rainbow, one we think begins in the Land of the Rising Sun.

The foregoing content reflects the opinions of Advisors Capital Management, LLC and is subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or construed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. Past performance may not be indicative of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. Securities investing involves risk, including the potential for loss of principal. There is no assurance that any investment plan or strategy will be successful.