Navigating Japanese equities: Strategies for hedging JPY exposure

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:

1. Weak Japanese yen: A weak yen can benefit Japanese exporters by making their goods more competitively priced in international markets, thereby boosting export revenues and profitability. It also increases the value of foreign earnings when converted back into yen, potentially leading to higher profits for multinational Japanese companies.
2. Negative/low interest rate: Japan is the only major economy that has negative interest rates. Despite expectations of normalization for Bank of Japan (BOJ), we do not expect any significant increases to interest rates, which will continue to facilitate access to low-cost capital for corporates. This environment incentivizes borrowing for investment and expansion purposes, allowing Japanese companies to fund growth initiatives at favourable terms.
3. Corporate governance reforms: Japan has implemented significant corporate governance reforms aimed at enhancing transparency, accountability, and shareholder rights. These reforms include measures to strengthen board independence, increase disclosure requirements, and promote shareholder activism, all of which improve investor confidence and corporate performance.
4. Return of inflation: The exit from deflation in Japan has given pricing power to corporates which is helping to expand profit margins and increase capex spending. This is a start of a positive feedback loop as higher wages could drive up inflation further.
5. Valuation discount: Japanese equities have long traded at a valuation discount compared to their global peers, presenting opportunities for value investors to acquire quality assets at attractive prices. This valuation gap may be due to factors such as perceived corporate inefficiencies, cultural differences, or historical market biases, providing potential for upside as market perceptions change. Despite the recent run higher in Japanese equities, the chart below shows that Nikkei 225 trades at a 12-month forward EV/EBITDA of 11.7x compared to that of S&P 500 at 13.8x. Strong earnings momentum is also justifying the recent multiple expansion.
6. Geopolitical risks: Japan's geopolitical position in Asia has historically been a stabilizing force, contributing to regional peace and security. The country's strategic alliances and diplomatic relationships have provided a peaceful alternative in the new normal of escalating geopolitical tensions. Geopolitical stability can attract foreign investment and foster confidence among domestic businesses.
7. Tech innovation: Japan is at the forefront of technological innovation, particularly in sectors such as robotics, artificial intelligence, and renewable energy. Investments in Japanese companies at the forefront of these technological advancements offer exposure to cutting-edge innovation and potential for significant long-term growth and profitability, especially in the current AI boom.
8. Warren Buffet’s nod: Warren Buffett, renowned investor and CEO of Berkshire Hathaway, has expressed confidence in the long-term prospects of Japanese equities. His investment in Japanese trading companies and positive remarks about the country's investment potential have bolstered investor sentiment and drawn attention to the opportunities in the Japanese market.
9. Low interest rate sensitivity: The balance sheet of Japanese equities tends to be net cash (or, negative net debt or higher cash levels relative to debt) given the prolonged low interest rate environment. This means that Japanese companies actually have a positive sensitivity to rising interest rates unlike most other equity markets including the US equity market.
10. The case for diversification: Investors exposed to the Japanese equity market get an overweight to industrials and consumer discretionary sectors and a significant underweight in the information technology sector. This has made Japanese market a key consideration for those looking to diversify away from a large exposure to the Magnificent 7 US stocks. Domestic investors have also had a compelling reason to diversify their larger bond holdings and shift portfolios towards equities as risks of normalization from Bank of Japan continue to take hold.

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:

1. Large exporters and familiar names, such as Toyota, Sony, Nintendo, Uniqlo-parent Fast Retailing, etc.
2. Semiconductor and chip stocks, such as Advantest, Tokyo Electron, Applied Materials, Screen Holdings, Keyence, Renasas, Lasertec, Arm-parent Softbank, etc.
3. AI ecosystem such as software and data storage companies such as Fujitsu, NTT Data, CyberAgent, Hitachi, etc. or chemical companies like Shin-Etsu Chemical
4. Warren Buffet holdings, that include Mitsui, Itochu, Sumitomo, Mitsubishi, Marubeni
5. Machinery and automation manufacturers such as SMC, Fanuc, Komatsu, Mitsubishi Heavy Industries and other
6. Renewable energy companies such as Kansai Electric, Tokyo Electric Power, Kyushu Electric, and others
7. Demographics that could make healthcare, pharma and education sectors interesting
8. ETFs such as iShares MSCI Japan ETF (EWJ), Global X MSCI SuperDividend Japan ETF (2564), iShares Currency Hedged MSCI Japan ETF (HEWJ) offer a broad exposure.

Understanding FX exposure

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.

Hedging strategies

Forward Contracts

Options

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 or Currency-Hedged ETFs

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).

Natural Hedges

Is currency hedging costly?

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.

Other considerations for market participants

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:

1. If investors expect yen to weaken over the holding period, one of the strategies mentioned above, including selling JPY forward or purchasing call options on USD/JPY, could be useful.
2. If investors expect the yen to strengthen over their holding period, it might be worth taking on yen exposure and switch out of hedged share classes as yen gains will add to the equity gains.
3. If yen is expected to stay sideways, it may still be worth looking at hedging given the positive carry of a long USDJPY position.

Ultimately, the decision to hedge or remain unhedged depends on investors' risk preferences, investment objectives, and market outlook.

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