Chart of the Month – Japanese Yen: to hedge or not to hedge?

Heart shaped hedges, Japanese gardens (« Johnson’s aeroplane” – INXS, 1984)

When it comes to buying Japanese equities for a non-Japanese investor, this emotional question always resurfaces: how do I manage the currency risk for the seeds I sowed in the Japanese garden, i.e. do I hedge the JPY currency risk on my equities or not?

As in recent years the Bank of Japan has made it clear it is determined to maintain or increase its quantitative easing program as well as all the required stimuli to prop up inflation to decent levels; the logical financial consequence should be a weaker currency. As can be seen on the chart of the month, from the end of 2014 until the middle of 2015, the Japanese equity market applauded loudly with a spectacular rise (red line) and at the same time currency traders understood that the Yen was deemed to weaken and went short, which limited the performance of the market for a non-Japanese equity investor who had not hedged the Yen (blue line).

For those who remember, this was a no-brainer strategy: you should buy Japanese equities because of the strong tailwind provided by both the Government (remember Mr Abe’s three arrows) and the Central Bank, and at the same time hedge the Yen in order to get the full appreciation of the market (and even a bit more thanks to the interest rate differential which made selling JPY forward versus most currencies profitable). And it has worked very well, but only for a limited period: when looking at the chart of the month, it was the right strategy for 6 to 9 months (from 2014 Q4 to 2015 Q3) but then it changed.

We, at Notz Stucki, stand in the “don’t hedge” camp.

After this exceptional period of strong equity market and weak Yen, things came back to normal and the market reminded investors that the inverted correlation between the Yen and Japanese equities was valid, not only on the upside for equities, but also on the downside: you get the best of both worlds when the market rises, but you get the worst of both worlds on the downside! Therefore, apart from some specific periods, it appears that it is much better to hold Japanese equities and leave the Yen unhedged because it reduces volatility significantly. During the selected timeframe shown on the chart of the month, although having hedged the Yen would have provided a better performance, the latter comes with much higher volatility and barely surpasses the levels reached two years ago (red line), whereas the blue line (running equity and currency risk) is at the High Water Mark level.

Chart of the Month: What is it good for?

What is it good for? Nothing!

What is Japan’s desperate effort to lower its currency good for? Well when having a look at the chart below the answer is clear: nothing! Japan’s central bank has increased its balance sheet by 20% just for 2016 so far, and the result is pretty surprising because during the same period the Yen has risen by almost 15%. This result is exactly the opposite of what Japan’s monetary authorities were looking for, and as a consequence Japanese equities have tumbled in 2016.

What is it good for_BOJ Balance Sheet_Chart of the month — What is it good for? BOJ Balance Sheet. Source: Bloomberg and Notz Stucki

Many strategists advised to go long Japanese equities and short the Yen in order to benefit from the supposedly good performance of the stock market without having to suffer from the Yen depreciation, whereas in fact the opposite strategy would have been a winning bet, i.e. go short Japan and long the Yen. The unwinding of this trade consisting in buying Japan and hedging its currency might explain part of this phenomenon, but in this case the question is why do investors sell Japanese equities?

In our view the best explanation comes from the fact that equity investors don’t believe in the global economic cycle and tend to buy non-cyclical stocks and markets essentially. The Japanese market has quite a high inherent cyclicality with large weightings in sectors like trading, finance and capital goods, which are all looked at with a high degree of suspicion this year, notably because of questions about China’s growth (and its implications on Emerging Markets), Europe after Brexit and the continuous problems of its banking system.

Nevertheless, with the US economy showing steady resilience and China apparently in a stabilization mode, investors should eventually consider the possibility of a better performance from cyclical sectors and markets: this would certainly help Japanese equities, which tend to show strong and rapid bouts of performance, with or without the help of the Yen.

The BoJ can try to counter the Yen appreciation by increasing again the size of its already ballooning balance sheet but as long as the global economic cycle does not improve, this policy will be, to quote Edwin Starr again, “nothing but a heartbreaker”.