There and back again. The BOJ’s surprise rate hike, resurgent recessionary fears, and a sharp unwinding of the yen carry trade sent Japan equities on a whipsaw, returning them to historic highs after briefly wiping out their gains for the year. Global financial markets have since rebounded, and the meltdown earlier this month now looks more like a brief tremor – though the way it unfolded underscores the vulnerability of Japanese markets to currency risks and how panicked investors could exacerbate wild swings in the foreign exchange and stock markets.

Positive earnings momentum. Japan’s equity market continues to outperform, with earnings surprises bolstering valuations that currently trade below their 10Y averages. Aggregated 1QFY24 results by Bloomberg show a 6.7% y/y increase in sales and a 10.8% rise in recurring profits for companies in the TOPIX index, surpassing expectations by 3.1% and 9.5% respectively. This suggests that earnings upgrades are likely. Full-year EPS growth is projected at 13% for this year and 18% for the next, outpacing historical averages. We believe Japan’s reflation is fuelling a broad-based recovery; earnings growth has been strong across most sectors with the exception of the utilities and consumer sectors, which should strengthen in the second half of the year on the back of continued wage growth.

Near-term volatility. In the fourth quarter, Japan faces several key challenges, from BOJ policy decisions to leadership changes in both Japan and the US; and to the resurgence of yen carry trades. Once the heightened uncertainties abate and carry trades normalise, we expect Japanese markets to pick up pace, driven by underlying structural forces that continue to reshape its economy. We discuss the key issues below.

Gradual tightening on the cards. The stepping down of Prime Minister Kishida has come at a crucial turning point for Japan. Economic growth surprised on the upside in the second quarter, expanding much faster-than-expected by an annualised 3.1%. This was a remarkable rebound from the -2.3% contraction at the start of the year, thanks to a strong rise in consumption backed by real wage growth as inflation-adjusted wages in June rose for the first time in more than two years. On prices, headline inflation has stabilised at 2.8% as of June, and is expected to ease towards 2.0% in the coming months.

Aligned with Kishida, most leadership candidates have endorsed the central bank’s gradual policy normalisation. BOJ Governor Ueda had reaffirmed in the parliamentary meeting on 23 Aug that the BOJ remains on track for higher interest rates, provided that inflation and economic data align with its forecasts. We do not expect significant policy differences that will derail the long-term outlook for Japan.

Leadership transition. Japan’s Prime Minister Fumio Kishida will be passing the baton to the newly elected Shigeru Ishiba. Through his three - year term, Kishida had championed the concept of ‘New Capitalism’ which emphasised structural wage growth, the revitalisation of domestic investments, and the transition to a digital society. Under his watch, Japan saw wage increases from labour negotiations hit their highest level in 30 years; he had also pushed for corporate reform to alleviate years of capital inefficiency, improving returns for shareholders at a time where renewed investor interest saw Japan’s stock market indexes surpass historic highs.

The next PM will continue to face challenges from higher costs of living amid slowing global growth and a challenging geopolitical environment. Key policy concerns surround supportive stimulus for Japan’s semiconductor sector, and the normalisation of interest rates. Against this backdrop, we continue to favour Japan’s bank and semiconductor sectors.

Easing yen volatility. The BOJ’s unexpected rate hike in July had led to a sharp unwinding of yen carry trades, resulting in a sudden yen appreciation and steep selloff in financial markets. Though the unwinding process is not fully complete, indicators such as non-commercial net yen positions and USD/JPY and UST-JGB yield gaps suggest that the most severe phase of the carry trade unwinding should be over. With speculative short yen positions turning neutral, the risks of JPY-buying interventions by the government has lessened. We believe the yen has largely stabilised, and could gradually appreciate amid narrowing yield differentials.

US elections overhang. Leadership changes in the US may have large implications on Japan as they affect policies surrounding global trade, national security, currency stability, investor sentiment, and overall economic conditions. Four key areas to watch are:

1. Trade policies: Changes in US trade policies could affect Japan’s exports and imports, especially if a more protectionist stance is adopted.
2. Security and foreign policy: The US-Japan alliance is vital for Japan’s national security. Policy pivots in US defence and international relations may in turn influence Japan’s security strategy and spending.
3. Currency fluctuations: US elections often create heightened market volatility, impacting the yen. A stronger yen could hurt Japan’s export competitiveness.
4. Monetary policy: Fed policies which may be influenced by the US elections affect global interest rates and capital flows, influencing Japan’s economy and monetary policy.

Selective themes prevail. We continue to maintain our neutral stance on Japan, recognising that current elevated uncertainties and currency volatility will weigh on risk appetites and corporate investments in the near term. We stay constructive on Japan in the long-term, with a focus on the semiconductor and IT services sector. Meanwhile, the financials sector will benefit from the BOJ’s rate normalisation. In addition, we expect the heavy machinery sub-sector in the industrials space to benefit from increased defence spending. We discuss the catalysts below.

BOJ regime shift a tailwind for Japanese banks. After years of being by bound by near-zero rates, we expect healthier NIMs for Japan’s banks as interest rates normalise. In particular, Japanese megabanks with broader deposit bases stand to benefit more from widening lending spreads. Net income and ROE continue to show steady expansion, and we see further upside given better returns from higher rates and more optimised balance sheet. Nudged by the government, Japanese banks have started selling off their large holdings of equity stakes in other Japanese companies. For example, MUFG and SMFG Inc have announced plans to divest JPY1.32tn (USD8.5bn) worth of strategic shareholdings in Toyota.

Rejuvenation of Japan’s semiconductors. We continue to favour the semiconductor and IT services sectors as beneficiaries of rapid AI adoption across industries supported by strong government support. Japan has already earmarked some JPY2tn (USD13.7bn) to rejuvenate its semiconductor sector, a significant increase from the JPY1.3tn (c.USD8.9bn) allocated previously. For example, Rapidus is one of its most ambitious efforts yet, with plans to manufacture advanced 2-nanometer chips to compete with TSMC and Samsung Electronics.

Increased defence spending. Highlights from Japan’s FY24 budget show the government plans to enhance national security through the deployment of an additional JPY1.1tn to its defence capabilities. Japan’s leading defence contractors have reported strong order books for military and space equipment in FY24, with expectations of rapid revenue expansion on the back of the country’s growing defence budget. The government’s commitment to nearly doubling its defence spending through FY27 to approximately 2% of its GDP is a marked departure from its traditional limit of defence spending at about 1% of GDP. Amid geopolitical instability, these factors could provide support for notable players in the heavy industrials and machinery sectors.