Why investors need to watch Japan closely this year

While almost every country in the world has been reducing interest rates from multi-decade highs, Japan has been doing the exact opposite.

The Japanese economy isn’t as dominant as it once was, while its sharemarket is only 4.8 per cent of world share indices.

However, it is critically important in terms of global financial markets, especially for foreign exchange and bond yields.

We need to keep a close eye on how the landscape is changing, and what it might mean.

Japan had a genuine rock star economy in the 1980s, driven by new infrastructure and productivity gains from the decades following World War II.

High quality goods built in advanced factories saw the economy boom, while the reliable, fuel-efficient cars it was producing were a global hit after the oil shocks of the 1970s.

All of this fuelled a massive property and sharemarket bubble.

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The Nikkei sharemarket index tripled in just four-and-a-half years, while Tokyo real estate was reportedly selling for more than 350 times its Manhattan equivalent.

At its peak, the land under the Imperial Palace was notionally worth more than the entire state of California.

A very strong US dollar was making Japanese goods even more attractive to American consumers, which put huge pressure on the US manufacturing sector and led to a large trade deficit.

The Plaza Accord agreement in 1985 saw the world’s biggest economies do something about that, and the greenback weakened sharply against the Japanese yen.

This helped reduce the US trade deficit, but it made life difficult for Japanese exporters.

To offset the tougher export environment, policymakers introduced expansionary monetary and fiscal policies, which contributed to the sharp rise in asset prices.

The bubble burst in 1990, sending property and share prices into a 30-year slump.

At its 2009 lows the Nikkei was more than 80 per cent below those heady days of late 1989, and it didn’t retake those levels until 2024!

Japan’s economy was plagued by deflation in those “lost decades”, with consumer prices going backwards in 12 of the 35 years following 1985.

The annual inflation rate over that period was just 0.5 per cent, compared with 2.5 in the US and 2.9 in New Zealand.

Deflation means prices are falling rather than rising (the opposite of inflation) and it isn’t nearly as good as it sounds.

Consumers stop spending money (goods will be cheaper next month, after all) and businesses become reluctant to invest or grow.

People hoard cash, the economy grinds to a halt and it’s an extremely difficult hole to climb out of.

So while the rest of us have been trying to knock inflation on the head Japan has been trying to create some, and it’s finally been working.

In early 2024 the Bank of Japan (BOJ) raised interest rates for the first time since 2007, ending an eight-year stretch of negative interest rates.

It’s hiked three more times since then, taking Japan’s equivalent of our OCR to 0.75 per cent.

As low as that is to the rest of us, that’s the highest it’s been since 1995.

More conventional monetary policy settings have been good for Japanese shares, which have had a cracking three years.

They’re up 90 per cent since the beginning of 2023, even outpacing the mighty S&P 500.

We’ve seen some big moves in bond yields too.

The 10-year Japanese Government Bond (JGB) yield has pushed above two per cent for the first time since 1999.

That’s a big deal, and it could ripple across other markets too.

At near-zero interest rates, the yen has been the funding currency of choice for decades.

Borrow in Japan for next to nothing, invest in a higher return asset elsewhere and pocket the difference (or the “carry”, as they say in market lingo).

Japan was the last domino to fall, and higher JGB yields now mean the era of free money is truly behind us.

With rates looking more attractive there, the yen depreciation could reverse and “carry trades” unwind.

Less Japanese money flowing into global assets could put upward pressure on yields elsewhere, such as in the US.

There’s every chance the Japanese market keeps performing well against this backdrop, but we might see changing sector leadership across other equity markets.

Sectors that perform well when interest rates are low might face more headwinds, while the so-called value stocks (like financials or industrials) could fare better.

These moves could also mean increased volatility in assets reliant on cheap money, such as crypto.

The BOJ meets eight times this year, and markets see at least one or two more rate hikes over that period.

Those modest increases might have a bigger impact than many expect, and we’d all be wise to pay attention.

Today’s levels of leverage, as well as the world’s interconnectedness, could see those ripples turn into waves in some parts of the financial ecosystem.

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