We see limited value in the equities market and we are keeping our powder dry for the time being. The biggest surprise of 2016 is the strengthening of the Japanese yen against the US dollar.
The result of the UK referendum to leave the EU increase risk aversion across a number of asset classes. On the currency front, Pound sterling fell against all major currencies with similar decline in the Euro to Dollar exchange rate.
During periods of risk aversion, similar to gold price in US dollar. There is a tendency for the Japanese yen to trend up on safe haven buying.
The yen touched 100 yen to dollar exchange rate during the night where the Brexit result came in. It is not unlikely that the BOJ is in the market selling the yen, not as direct intervention in keeping the yen exchange rate weak but limit volatility and orderly fall in the currency.
The rise in yen to dollar rate this year has wiped out all of the gains it made after Kuroda promised to bazooka the currency. Previous depreciating JPY rate cushioned the weak Japanese economy which now will become a headwind.
Dollar vs Yen Forecast
FX market goes in cycles. The yen has being weakening since mid 2012. Our Japanese yen outlook is for further strengthening as markets are clearly on risk off mode.
The stronger dollar yen is partially driven by US interest rate expectations as well as risk aversion. The Fed is expected to continue to raise interest rates later 2016.
While initial sign was that the rally in US dollar is petering out. It had a nice bump after the Brexit result. Within this context, we are more cautious on Aus dollar to US going forward.
Ironically, the worse the economic fundamentals look of Japan and Global economy. It is more likely that major yen exchange rates will appreciate. The size of Japanese investment outside Japan should not be under estimated.
When global economic outlook is shaky, Japanese corporate and asset management initiate flow of funds back to Japan. It is also not helpful that USD JPY is a funding currency in carry trades.
We think one of the best way to take advantage of stronger yen forecast is to sell EUR JPY. JPY rally outpaced Euro’s rally against the dollar. There are increasing political risk in Europe with risk of contagion in the aftermath of UK’s vote to leave the EU.
On the monetary side, the ECB is at the early stage of monetary easing and will have its hands full supporting the banking sector. Japanese monetary policy is at the tail end of the loosening cycle. As result of BOJ’s quantitative easing program, it is a top 10 owner in 90% of Japanese companies. It is interesting to see how the BOJ gets out of these positions, if ever.
The last 2 years saw Japan Inc. benefited enormously from the weak currency. This free ride is over which is reflected in the Nikkei 225 return year to date. Management guidance for the next year earnings already accounted for the 10% – 15% currency headwind. The prospective currency headwind even without further JPY appreciation means lower forward earnings.
We do see some value in specific names in Japan however will only step in during wash out periods. The bear market in Japanese equities will only end after signs that the currency rally has petered out.
Ironically, Japan current account is improving due to gradual restart of the nuclear plants. Recent deterioration of the trade deficit was primarily caused by the import of LNG (See our analysis of ORG ASX which is ramping up LNG exports to China as well). Our prediction is that net trade figures will gradually improve as more nuclear plants come back online as more expensive LNG imports is replaced by coal.