US-China tensions leave Japan in geopolitical, financial sweet spot – for now

Right now, Japan ticks many of the boxes that matter to fund managers, thanks to its geopolitical appeal and outlier status on monetary policy
It is by no means immune to the turmoil in the global economy, however, especially if China’s economy continues to struggle and the US slips into recession

Nicholas Spiro

Published: 3:30pm, 19 Oct 2023

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As another geopolitical crisis threatens to escalate dramatically and a disorderly sell-off in global debt markets compounds the fallout from the steep rise in interest rates, the list of safe havens that investors can retreat to is getting shorter and shorter.

Even the supposedly stable United States Treasury bond market – the bedrock of the global financial system – has become exceptionally volatile. Since August 31, the yield on the benchmark 10-year Treasury bond has surged from 4.1 to 4.9 per cent, its highest level since 2007. The move was so sharp that analysts have struggled to explain the cause of the sell-off.

While there is no such thing as absolute safety in times of extreme turbulence – even the price of gold, long touted as the ultimate haven asset, has proved volatile in recent years – there are plenty of examples of assets that outperform.

Yet, every so often a new investment theme emerges, usually based on a particular trend as opposed to a specific sector. Investors love a good story, especially one that is about economic resilience and is underpinned by a confluence of favourable shifts in the global economy. Right now, Japan ticks many of the boxes that matter to fund managers.

While Asia’s second-largest economy has been a notoriously fickle market for equity investors, holding much promise yet ultimately proving to be a disappointment, there are reasons to believe this time might be different.

Since the start of this year, the Topix – one of Japan’s main stock market indices – has soared 20 per cent, outperforming the buoyant S&P 500 and outpacing the gains of the Nifty 50, one of the gauges of India’s booming equity market. Although Japanese shares are still trading below their all-time high in December 1989 – just before the bursting of Japan’s epic asset bubble – the last time the Topix stood at such a lofty level was in 1990.

Tourists view Tokyo skyscrapers from the observation deck at the Tokyo Metropolitan government headquarters in Tokyo, Japan, on October 18. While the Japanese economy has been a notoriously fickle market for equity investors, there are reasons to believe this time might be different. Photo: EPA-EFE

However, it is the catalysts for the sharp rally that have caught investors’ attention and suggest things seem to be coming together for Japan. While several domestic and external factors are at work, two in particular stand out in the current environment: Japan’s geopolitical appeal and its position as an outlier in global monetary policy.

As tensions between the United States and China intensify, Japan has positioned itself as a stable, Western-aligned and strategically important economy that stands to benefit from the reshaping of supply chains and efforts by the US and Europe to “de-risk” their economic ties with China. Plans by some of the world’s biggest semiconductor firms to increase production in Japan have reinforced the view that “friendshoring” is taking hold.

Geopolitical realignments have also contributed to growing demand for Asian investment products that exclude China. Having diversified away from Japan following the bursting of its asset bubble, Asia-focused fund managers are now searching for ways to maintain exposure to China without being directly invested in the country. Not only is China Japan’s largest trading partner, Japan itself is the only deep, investible and relatively safe market in Asia, increasing its appeal among investors.

Just as importantly, Japan remains the odd one out in monetary policy. While other major central banks in advanced economies have raised interest rates aggressively, the Bank of Japan (BOJ) is keeping its ultra-loose policy firmly in place.

While there is intense debate over the timing and consequences of a normalisation in policy, the BOJ is in no rush to raise rates. A premature tightening risks snuffing out the first period of sustained inflation in decades.

Bank of Japan Governor Kazuo Ueda speaks during a press conference after holding a monetary policy meeting at the BOJ headquarters in Tokyo on September 22. Japan’s central bank stuck to its ultra-loose monetary policy in September, though officials face increasing pressure to turn more hawkish as the yen weakens and after fresh data showed inflation remained stubbornly high. Photo: AFP

That the BOJ will have little choice but to exit its negative rate policy in an cautious manner – particularly given Japan’s heavy public debt levels and its high share of floating rate mortgages – adds to the sense of predictability about Japan.

Furthermore, an investor-friendly policy agenda is a boon to Japanese equities. Long-awaited corporate governance reforms initiated by the Tokyo Stock Exchange aimed at forcing companies to improve shareholder returns are likely to lead to a healthier and more liquid stock market.

In a report published on October 15, Morgan Stanley said that despite all the challenges faced by markets from rising bond yields, geopolitical risk and slower growth, it was important to “recognise that the secular bull market for Japanese equities has arrived”.

A man walks past an electronic quotation board displaying stock prices of each listed company at the Tokyo Stock Exchange on October 10. Photo: AFP

Still, while Japan is in a geopolitical and financial sweet spot, it is by no means immune to the turmoil in the global economy. The surge in bond yields has driven up Japan’s 10-year yield to its highest level in a decade, putting another nail in the coffin of the BOJ’s discredited yield curve control policy.

Although wage growth remains tepid, inflation excluding fresh food is still above the BOJ’s 2 per cent target while the yen is trading close to multi-decade lows versus the US dollar, fuelling inflation and exacerbating the cost-of-living crisis. If global bond yields keep rising and the US economy remains resilient, Japan’s ultra-loose policy will become untenable, increasing the risk of a disorderly exit.

On the other hand, a “hard landing” for the US economy and a deeper downturn in China would hit Japan hard, especially if the yen was to strengthen sharply as companies repatriate foreign assets. But then every major market would suffer if the US and Chinese economies took a turn for the worse.

Right now, Japan is in a favourable position. Whether this time really is different remains to be seen.

Nicholas Spiro is a partner at Lauressa Advisory