The Nikkei 225 Stock Average has been performing exceptionally well this year, outpacing global peers and reaching its highest level in almost 33 years last week. The index has gained 17.6% this year, but according to Adam Cole, chief currency strategist at RBC Capital Markets, most of the outperformance is due to the recent weakness in the Japanese yen rather than any domestic policy or economic performance improvements in the country.
While investors cite corporate governance reforms, a push to return cash to shareholders, and cheaper valuations and lower volatility relative to the US market as the drivers of Japan’s outperformance, Cole emphasizes that it is the weakness in the Japanese yen that accounts for most of the recent boom. Billionaire investor Warren Buffett has contributed to the excitement by increasing its stake in five Japanese trading conglomerates, thus increasing its equity exposure to Japan more than any other country outside the US.
The Nikkei index has been the best performing major market index this year, solidly outperforming the S&P 500 index, which has risen around 7% so far this year. The iShares MSCI Japan ETF, which tracks the MSCI Japan Index, is also up 9.7% as compared to a 7.5% gain for the S&P 500-tracking SPDR S&P 500 ETF Trust.
Cole, in a note, highlights the currency chart that shows the relative performance of Japanese equities, which have recently followed the dollar/yen currency pair closely. Because exporters are so prominent in listed Japanese companies, this should come as no surprise.
SOURCE: RBC CAPITAL MARKETS, BLOOMBERG
The US dollar has been at its strongest level versus the Japanese yen since last November, currently at 139.45 yen on Wednesday. According to Cole, economic activity in advanced economies has become less sensitive to exchange-rate movements over the last 30 years, as foreign exchange movements tend to be “fully passed through to trade prices and hence export margins.” This implies that equity markets with high international exposure have become more sensitive to exchange-rate movements, such as the Nikkei index.
Cole also notes that Japanese equities are at almost the same level compared to the MSCI World Index, which tracks large and midcap equity performance across all 23 developed markets, as they were 30 years ago rather than a 30-year high. This suggests that if the yen continues to weaken as expected, Japanese stocks may continue to outperform other markets.
Cole cautions, however, that the equity market rally is due to the currency, and not the other way around, which implies that this “tells us little about domestic policy or economic performance in Japan.”
