The land of the Rising Sun, and Falling Markets: Japan's Economic Challenges

“Land of the Rising Sun” is a poetic nickname for Japan which stems from its location to the east of the Asian continent, where the sun rises. However, this optimism was not mirrored in the Japanese stock markets over Q3 2024. Instead, the markets experienced a bumpy ride, reflecting economic challenges rather than the anticipated growth and stability.

A background to the Japanese economy
A "three arrow" policy, also known as Abenomics, was introduced by former Japanese Prime Minister Shinzo Abe. The metaphor of the rising sun aligns with the optimism and forward-looking nature of these reforms, which aimed to usher in a brighter economic future for Japan. The “three arrow policies” were focused on: 

1.    Monetary easing: The BoJ increased the amount of money in circulation in the economy and set negative interest rates to fight deflation and to help the economy grow. Deflation is when prices of goods and services decrease over time. Although falling prices may sound good in theory, it can be harmful to an economy because people might delay buying goods and services as they expect prices to drop further, which can slow down economic growth.

2.    Fiscal stimulus: The government spent more money on infrastructure such as building roads and bridges to create jobs and increase demand for goods and services.

3.    Structural reforms: These changes aimed to make Japan’s economy stronger by implementing corporate reform in different industries, encouraging private companies to invest, and improving how businesses are run.

What happened in Japanese stock markets over the summer?
Japan's stock market saw strong performance over the summer, with a gain of 13% year to date by 11th July 2024 in USD, source MSCI Japan. However, over the next 25 days, the market plummeted, erasing most of its gains. On 5th August, the market experienced its biggest drop since 1987's Black Monday but a recovery soon followed. It was concerns over weak US economic data, recession risks and scepticism around artificial intelligence (AI) that initially rattled investors. The Bank of Japan's (BoJ) unexpected rate hike on 31st July further triggered a global unwinding of yen-funded carry trades. A carry trade involves borrowing in a low-interest-rate currency (like the yen) and investing in higher-yielding assets in other markets. This strategy became popular when BoJ rates turned negative in 2016 and further intensified post-pandemic with rising global interest rates. However, the carry trade's profitability diminished as US asset prices fell and BoJ rates rose. This made yen loans more expensive for investors, which caused them to sell their assets, leading to sharp drops in the market.

Market events that followed
Last month saw a snap Japanese election (27th October 2024), which resulted in the ruling Liberal Democratic Party (LDP) led coalition losing its majority position in the Japanese Diet (the Japanese parliament equivalent). This adds some uncertainty to the economic and market reform agenda that had been pursued by Japanese authorities since the Abe-led ‘three arrows’ policy of the mid-2010s. 

Post the snap election on 27th October, new Prime Minister Shigeru Ishiba will now enter a period of negotiations to try to expand his current coalition. It is uncertain what policy concessions will need to be made in order to form a government or indeed if this will even be possible. Opposing views amongst historic parties could result in a period of material policy uncertainty, especially regarding the fiscal and monetary regimes that have supported Japan’s recent departure from its decades long deflationary regime. Japanese markets reacted to the news with the yen weakening and expectations of a further increase in interest rates by the BoJ before year end (as at end October). However, global markets were largely unimpacted by the developments in Japan.

In order to deal with uncertainty, portfolios should be designed to be resilient to the outcome of political events in a particular country. By diversifying return sources by sectors (e.g. healthcare), asset type (e.g. bonds) and geography, investors can ensure that adverse events are less impactful on portfolios. Holding specific hedges to protect assets against downside risks can also be beneficial alongside a genuinely diversified portfolio.

Source: FactSet, Japanese equity market return shown by MSCI Japan Total Return Index in USD 

The Noise

• The Bank of England cut interest rates by 0.25 percentage points to 4.75% on Thursday after UK inflation dropped below 2% in September for the first time since 2021. While this week’s announcement is in line with expectations, they tempered any future expectations as the BoE signalled that further rate cuts are unlikely before early 2025. This is largely due to new inflation forecasts following the UK Budget last week, in which UK chancellor Rachel Reeves increased taxes and loosened fiscal policy. Before the Budget, many had speculated that we’d see an additional rate cut in December. BoE caution could also slightly stem from an ‘upside risk’ to goods and food following Trump being elected, which they alluded to in the meeting minutes. Trump’s potential policy on tariffs would affect British exports, but if and how he implements this remains to be seen. Despite this forward-looking caution, the market reacted positively to the decision, with the pound strengthening by 0.6% against the US dollar on Thursday.

• The US Federal Reserve cut interest rates by a quarter point on Thursday, citing "ongoing strength" in their labour market. While October’s jobs report showed modest growth—with 12,000 new jobs added despite the disruptions of two major hurricanes—it highlighted that the job market remains solid. Additionally, inflation has fallen from a peak of 9.1% in June 2022 to a figure closer to the Fed’s 2% target, reinforcing the rationale behind the rate cut. This decision was widely expected and aligns with market forecasts. The Fed, however, provided minimal guidance on future rate moves, likely waiting to evaluate the incoming president-elect's policies, particularly on their potential inflation related consequences. Following the rate cut and the boost from an election-related rally, US equity markets saw strong gains, rising roughly 4% for the week. This market movement can largely be attributed to the combination of the Fed’s rate cut and election related volatility.

• The European Union's greenhouse gas emissions dropped by 8.3% in 2023, marking one of the largest declines since 1990, excluding pandemic-related reductions, according to a report released this week by the European Commission. This decline is noteworthy, as the EU accounts for approximately 6% of global emissions. A key driver of this progress was a reported 20% reduction in electricity generated from fossil fuels, while renewable energy now constitutes nearly 45% of the EU's total energy production. This achievement aligns with the European Climate Law, which sets legally binding targets for climate neutrality by 2050 and a 55% reduction in emissions by 2030, relative to 1990 levels. The progress underscores the EU's ongoing efforts in its renewable energy transition, bolstered by their reaffirmation of a 2035 ban on new CO2-emitting car sale this week as well.

The Numbers

The Nuance

As Donald Trump claimed victory in the 2024 US election, markets have done what they do best: react, speculate, and scramble to find stability amidst the short-term uncertainty. While the economic implications of Trump’s upcoming tenure remain uncertain, we can comment on how markets have behaved in relation to the US election this week.

At the start of the week, markets had pre-election jitters, with polls showing near parity between the presidential candidates. Sensing the uncertainty, investors positioned themselves cautiously and braced for market volatility. On Monday, the U.S. dollar slipped against both European and Asian currencies as traders adopted a wait-and-see approach, which reflected the unanimous uncertainty. 

As Americans began heading to the polls on Tuesday, Bitcoin surged up by +4.3%, hitting $69,984 — an early sign that some were betting on a Trump victory. Cryptocurrency has been buoyed by Trump’s rhetoric positioning him as the "pro-crypto" candidate.

Wednesday morning brought clarity: Trump appeared to have secured the majority in swing states, and the market reacted accordingly. The US dollar surged the most it has in two years, climbing +1.5% against European currencies in the Dollar Index, and US bond yields jumped in tandem. Bitcoin’s bullish rally continued, climbing an additional +3%, as markets embraced for a potential pro-business president.

The post-election fallout, after Trump’s victory was announced, saw stocks like Tesla — whose CEO Elon has been a strong supporter of Donald Trump — surge over +13%. However, the renewable energy market tumbled, driven by concerns that Trump may dismantle the subsidies and tax incentives introduced under Biden’s administration. 

Once the dust had settled, foreign exchange markets saw the dollar weaken, halving its election rally earlier in the week. Further, on Friday, US treasury yields fell back to pre-election levels, decreasing by 0.05 percentage points to 4.3 per cent. This just goes to show that volatility in the markets was to be expected, yet long-term investors should remember that such short-term election-driven market swings rarely reflect the broader performance of long-term investments.

We will have to wait and see what Trump’s second term holds, in terms of economic policy changes, regulatory shifts, and their potential impact on the markets. In the meantime, staying focused on long-term goals and maintaining a diversified portfolio will be key as markets continue to adapt to the evolving political and economic landscape.