Japan’s inflation, growth and currency conundrum

This week is a busy one for central banks. Hot on the heels of the European Central Bank cutting rates by 25 basis points last Thursday, Bank of England officials are convening and the Federal Reserve is likely to finally lower the base rate at this week’s meeting (see our thoughts on it here). And then later on we have the Bank of Japan (BoJ) setting interest rates as well. 

Spare a thought for BoJ governor, Kazuo Ueda. His task of steering Japan’s monetary policy has been complicated by the recent yen volatility. And, all the while he must carefully reflate the economy, without derailing a slow recovery which is facing headwinds from rising global uncertainty.

Investors widely expect officials to keep the key rate at 0.25% after a rate rise in late July which was the second increase since the central bank exited its zero-rate policy in March.

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However, they will scrutinise any communication for hawkish comments to gauge when rates may go up again, which will likely give the yen another boost.

Since hitting a multi-decade low on 3 July, the yen has broadly recovered. This turnaround is largely due to expectations that the interest-rate gap between the US and Japan will narrow further in the coming month. Currently, most bets for further BoJ tightening centre around December or January. 

The economy remains on track

The yen jumped again last week, both in response to the more risk-off mood in global markets and after board member Junko Nakagawa signalled that the central bank will continue to adjust policy going forward, provided the economy performs in line with their projections. This is a stance that BoJ officials have reiterated at public engagements since the end-July policy meeting.

Revised gross domestic product (GDP) and wage data released after the July meeting showed that the economy had remained on track in the months after the BoJ raised rates for the first time in 17 years in March. Core price inflation (CPI) data throughout the summer months showed an acceleration in inflation which was ahead of consensus. The Japanese government also upgraded its monthly economic assessment for the first time in 15 months, citing signs of a recovery in consumption.

While it will take time for wage increases to be reflected fully in consumption data, the trajectory is a positive one. That should benefit those companies with a high exposure to the domestic economy.

Good Value for investors

Two types of Value sector should benefit from Japan’s shift away from decades of structural deflation. The first are asset-heavy, domestic-focused sectors such as railways, construction, real estate and retail. Secondly, the financial services industry stands to receive a boost.

If the BoJ can manage monetary policy normalisation decisively, a stronger yen should keep CPI under control, real wages should grow and consumer sentiment should improve.

This should naturally benefit Japan’s retailers and contractors as well as companies with significant exposure to real estate (which is a natural inflation hedge), including railways and developers.

Long-term gain, short-term pain?

The government is also actively encouraging retail investors to shift their savings into investments as a pillar of Prime Minister Fumio Kishida's vision of a "new form of capitalism," which emphasises concepts such as better wealth distribution and a virtuous cycle of growth.

Over 50% of Japanese household wealth is currently held in cash, compared to around 13% in the US. With USD 7.7 trillion tied up this way, even a modest shift could provide a powerful tailwind for the equity market, but more specifically for the financial services industry in Japan.

This potential shift into risk assets, in addition to an environment of rising domestic interest rates and a relentless public drive to improve corporate governance keeps us optimistic about Japan’s long-term investment prospects.

That said, with over a fifth of Japan’s economy dependent on exports, in the context of rising global uncertainty, we are cautious about the short-term outlook.

Green shoots for green stocks

Responsibly invested stocks have not seen a lot of love in recent years, marred by underperformance and consequent capital outflows. High interest rates have posed headwinds for more capital-intensive environmental, social and governance (ESG) stocks, such as renewables, and the robust performance of fossil fuels and mega-cap tech—typically underweight in ESG funds—has further strained returns. This has been compounded by the anti-ESG movement across certain US states, which has dampened some investor sentiment on ESG.

Over the past 18 months, ESG equity funds, particularly those classified as Article 9 under EU SFDR, have struggled.[1] Underperformance has largely been driven by thematic funds which tend to be more exposed to rate-sensitive stocks, such as clean energy, and underweight tech. However, the picture is not all bleak, as fixed income ESG funds have shown resilience, with Article 8 funds outperforming their non-ESG Article 6 counterparts year-to-date in 2024.

Amidst a more uncertain, macro-oriented market backdrop, investors have become increasingly short-termist and less patient for returns. The underperformance of thematic funds, has prompted a shift from the asset class to more generalist sustainability strategies. These funds tend to be less constrained and better positioned to navigate challenging market environments.

Despite these challenges, there are promising signs on the horizon. Valuations in the S&P Clean Energy Index have markedly declined from their peaks in 2020 and clean energy stocks are now looking relatively ‘cheap’ versus historical levels. This provides a more attractive entry point for investors, positioning the sector for potential recovery.

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Furthermore, the prospect of lower interest rates could serve as a tailwind for rate-sensitive ESG stocks and the recent market widening could benefit small- and mid-cap ESG stocks. Upcoming ESG regulation and legislation, particularly in the EU, could also increase the financial materiality of certain ESG themes and pose tailwinds for ESG investing.

While the path forward for ESG remains complex, the recent uptick in ESG fund performance and flows indicates that the market may be stabilising. With multiple tailwinds on the horizon, ESG investments could be poised for a bit of a resurgence, offering renewed opportunities for sustainability-focused investors.

With contributions from Emily Badger, a portfolio manager at the Japan CoreAlpha team and Jess Henry, an RI specialist at Man Group.