Written by Carl Vine, Fund Manager for M&G Japan Fund and M&G Japan Smaller Companies Fund
The Japanese market has experienced the biggest 3-day drawdowns in the market’s history. What happened? What is the market telling us?
Market drawdowns of this magnitude are typically associated with major and unexpected economic events; the Lehman crisis, the great Eastern Earthquake, the COVID-19 crisis and so on. In this case, it would appear we are talking more about a butterfly effect of complicated, global, cross-asset correlations more than an unexpected economic iceberg; more 1987 than 2007.
Last week, the BOJ raised the policy rate 0-0.1% to 0.25%. Despite flagging a possible increase in rates since December of 2022, this was somehow slightly more hawkish than the consensus expected. At the same time, whilst the Fed itself said nothing, economic releases in the US resulted in a dovish shift in fed-funds expectations. The confluence of the two reverberated through FX markets and the yen, finally, started to strengthen. As this unfolded, short term and aggressive volatility-contagion ensued. Japanese equities were at the tip of this spear, but regional equities across Asia also experienced ripples. The long-short equity community in particular appears to have unwound exposures rapidly.
What can we divine from these moves? At the fundamental level, arguably not much. It seems fair to say that global markets have become somewhat more concerned about US growth. As the world’s largest economy, this bears serious consideration. In Japan, whilst this should not have been new news, the market has finally woken up to the fact that rates will not be zero forever. Beyond this, it would seem the moves speak more to financial market positioning rather than a sudden and meaningful shift in the fundamental, economic reality.
Despite unusual volatility, sentiment on the ground in Japan has been relatively calm. The Japanese economy continues along its path of structural improvement, especially in the listed corporate sector. Stock market earnings remain solid thanks to genuine self-help and ongoing structural reform of business models and capital policies. Earnings grew some 12% last financial year and earnings in the current fiscal year appear to be off to a strong start.
What are we doing following these moves? As is typical of such “volatility fits”, correlations in both the downdraft and the recovery tends to be very high. The opportunity for the investor, then, is to either find “baby-with-the-bathwater” situations or to add portfolio beta. In our case, we have used both playbooks. We have added to some names where undue selling was seemingly illogical and related purely to contagion. We have also tilted modestly away from defensive names towards names that were being sold indiscriminately.
We are not in the business of predicting market episodes, but we are alert to their ongoing possibility. Indeed, we have noted a number of times in the past that it would be heroic to expect the normalisation of interest rates, after 20+ years of experimental policy, to happen without the market slipping on an occasional “banana skin”. Well, this just happened – and that’s OK. With weak hands seemingly flushed out in recent days, the price one must pay for ownership in Japan has shrunk despite robust fundamentals. We remain of the opinion that Japanese equities represent an attractive, structural investment opportunity with an asymmetric prospective payoff profile.
