Macro: Sandcastle economics
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Head of FX Strategy
Summary: Investing in Japanese equities presents lucrative opportunities amid recent market highs and a diverse industry landscape, although foreign investors could face challenges due to FX exposure. Hedging via forward contracts, options, or currency ETFs, however, can mitigate FX risk. Moreover, positive carry makes hedging cost-effective and can help investors to focus on the underlying fundamentals of Japanese stocks without being exposed to currency fluctuations.
Japanese equities have been a focal point for global investors seeking growth opportunities and portfolio diversification, and Nikkei 225 has recently breached its 35-year highs to climb to fresh record highs.
With the world's third-largest economy boasting a rich tapestry of industries ranging from automotive and technology to healthcare and finance, Japan offers an array of investment options for discerning investors.
However, while the potential rewards of investing in Japanese stocks are enticing, navigating the intricacies of foreign exchange (FX) exposure remains a critical challenge as fluctuations in FX can significantly impact the returns of foreign investors holding Japanese stocks, adding an extra layer of complexity to their investment decisions. But appropriate hedging strategies can help investors optimize their portfolios for long-term success in the Japanese market.
Japan is a market where macro meets momentum. Despite the challenge of an aging population, Japanese companies have boasted of large global operations and technological innovation along with a stable regulatory environment. Some of the other tailwinds that have contributed to fresh highs in the Japanese equity markets include:
These range of tailwinds have meant that there are a number of opportunities in the Japanese market that investors can position for. Some examples for consideration include:
Foreign exchange (FX) risk is the potential volatility in the value of investments denominated in foreign currencies due to changes in exchange rates. For investors, FX exposure arises when they invest in assets denominated in a currency different from their own. Fluctuations in exchange rates can significantly impact investment returns, leading to gains or losses depending on the direction of the currency movements.
In the context of Japanese equity investments, FX exposure is particularly relevant for foreign investors holding assets denominated in Japanese yen (JPY). The exchange rate between the JPY and the investor's home currency determines the value of their Japanese equity holdings when converted back into their home currency. Therefore, changes in the JPY exchange rate directly affect the returns realized by foreign investors in Japanese equities.
The impact of FX exposure on Japanese equity investments is twofold. First, currency movements can amplify or dampen investment returns, potentially magnifying gains or losses for foreign investors. A weakening JPY, say against the USD, means US investors receive fewer dollars when converting the returns of their Japanese equity holdings, potentially offsetting the positive returns they made in Japanese equities. The chart below shows returns for Nikkei 225 in 2023 amounted to 28%, but JPY depreciation eroded the returns to 19% for a US-based investor. In some cases, if the yen weakness is significantly larger, then a foreign investor may still end up making a loss after converting their positive returns from Japanese stocks to base currency.
Secondly, the returns of Japanese equities are inversely correlated to JPY due to heavy export focus and safe-haven attributes of JPY. This means that JPY is generally expected to be on a weakening trend when Japanese equities perform strongly. As such, currency-hedged exposures can help mitigate this risk, allowing investors to focus on the underlying fundamentals of Japanese stocks without being exposed to currency fluctuations.
Consider an investor who wants to hedge against the risk of JPY depreciation, or a higher USDJPY. They will need to buy a call option on USDJPY to lock in the strike price at the current premium, and execute the call option in case the USDJPY rate is higher than strike price at the time of option expiry.
Currency exchange-traded funds (ETFs) are investment funds that track the performance of a specific currency or a basket of currencies relative to another currency, such as the USD. For investors seeking a passive way to hedge FX exposure, currency ETFs offer an efficient and cost-effective solution. By investing in currency ETFs that reflect the performance of the JPY relative to the USD, investors can offset potential losses resulting from a weakening JPY. A bullish USD ETF could be useful to hedge risks of yen weakness. Meanwhile, currency-hedged versions of broad Japanese equities have also been popular. Key examples include iShares Currency Hedged MSCI Japan ETF (HEWJ) and WisdomTree Japan Hedged Equity ETF (DXJ).
One of the most common beliefs about currency hedging is that it’s costly. Although this may be a valid in some cases, it doesn’t hold true universally. The cost of hedging depends on the interest rate differentials between the base currency and currency of investment, along with market expectations for future exchange rate movements.
Currency hedging for a US investor with positions in Japanese equities can be relatively expensive due to wide interest rate differentials, but the cost of hedging can be offset by the carry trade opportunities available in the USDJPY currency pair.
In a carry trade, investors borrow funds in a low-interest-rate currency (the funding currency) and invest the proceeds in a higher-yielding currency (the target currency). The attractiveness of the carry trade is amplified when there is a positive interest rate differential between the two currencies. The interest rates in Japan have been lower than those in the US, making the USD a higher-yielding currency compared to the JPY. As a result, US investors can potentially earn a positive return from the interest rate differential, known as the carry, by funding their Japanese equity investments with US dollars.
In order to hedge currency exposure in Japanese equities, US investors could consider a long USDJPY position, that is buy USD and sell JPY. In this scenario, the trader is effectively borrowing JPY at the lower interest rates prevailing in Japan and investing in USD, which has higher interest rates compared to JPY. By holding the long USDJPY position, the trader earns the interest rate differential between the two currencies. If USDJPY goes up during the holding period, the return in Japanese equities are amplified by the long USDJPY position which yields both exchange rate upside and carry advantage. However, if USDJPY weakens, there is still a chance that carry returns could offset the movement in FX rates. However, the investor loses money on the FX hedge if the slide in USDJPY is large enough to offset the carry. But their returns from Japanese equities will be amplified due to the strength of the Japanese yen.
Overall, the carry trade opportunity in the USDJPY currency pair can make currency hedging relatively inexpensive for US investors with positions in Japanese equities, thereby allowing them to manage currency risk effectively while potentially enhancing their overall returns.
It is worth noting that currency hedging requires active monitoring and regular adjustment in portfolios. While long-term investors may decide to leave their allocations to global equities unhedged, investors more sensitive to short-term volatility may prefer some form of currency hedging.
A view on FX moves is also necessary to understand whether hedging would make sense or not. In the case of US investors looking to add exposure to Japanese equities, the expected move in USDJPY will be key to determine if hedging is needed or not. For instance:
Ultimately, the decision to hedge or remain unhedged depends on investors' risk preferences, investment objectives, and market outlook.
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