The Federal Reserve's interest rate cut expectations have been lowered again and again, and the US-Japan interest rate differential has climbed, with the US dollar against the Japanese yen continuously setting new highs since 1990 this week. As of the time of writing, the exchange rate of the US dollar against the Japanese yen is 154.28, down 9% from the beginning of the year, and the market's expectations for the Bank of Japan to intervene again are continuously heating up.
Since 2023, the sharp depreciation of the yen has pushed up the pricing of Japanese stocks, making yen assets a global value lowland, attracting foreign capital to flow into Japanese stocks. Now the question arises, if the yen continues to depreciate, how much momentum is there for the rise in Japanese stocks?
On April 17, a team led by Morgan Stanley analyst Rie Nishihara pointed out in a report that the depreciation of the yen is usually a favorable factor for corporate profits. If the yen continues to be weak and the exchange rate of the US dollar against the yen remains at a high level of 155, the profit expectations of Japanese companies may be revised upwards due to exchange rate factors, changing from the current forecast of decline to growth.
However, Morgan Stanley emphasized that when the yen exchange rate falls below 152, the Japanese stock market begins to underperform the US stock market, which may have a negative impact on the Japanese stock market. Excessive yen weakness has the following three adverse effects on the stock market: first, the impact on the real economy (i.e., consumer spending); second, it exacerbates the gap between companies and households, export companies and domestic demand companies, which is particularly disadvantageous for small and medium-sized enterprises; and third, it leads to a decline in the return rate of foreign investors.
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On the same day, Ken Kobayashi, the chairman of the Japan Association of Corporate Executives, said at a press conference that Japanese financial authorities should consider coordinating foreign exchange market intervention with other countries to support the yen. Kobayashi pointed out that due to the yen's exchange rate against the US dollar reaching its lowest point in nearly 34 years, Japanese small and medium-sized enterprises are suffering from the problem of rising import costs of raw materials.
To a certain extent, the weakness of the yen boosts corporate performance.
Morgan Stanley believes that inflation is difficult to reduce, which may keep US interest rates at a high level for a long time, meaning that the yen will continue to be weak. On the one hand, the depreciation of the yen will reduce the export costs of Japanese export companies, such as manufacturing and electronic machinery companies, which will promote the growth of corporate profits. The profit expectations of Japanese companies may be revised upwards due to exchange rate factors:
Looking at the linear relationship between the yen exchange rate and corporate profits, the earnings per share (EPS) of the constituents of the Tokyo Stock Exchange Index and the yen exchange rate, for every certain decline (i.e., depreciation) in the yen exchange rate, corporate profits will correspondingly improve by a certain percentage.
If the exchange rate of the US dollar against the yen remains at 155 yen in the fiscal year of 2024, based on the aforementioned fixed sensitivity assumption, it is estimated that EPS will be boosted by about 8%.
Looking at the net profit ranking of Japanese companies listed in 2023, the performance of the top Japanese companies is basically related to overseas revenue. In particular, the Japanese automotive industry, represented by Toyota, is expected to achieve a net profit increase of 2.9 trillion yen in the fiscal year of 2023, accounting for 60% of the net profit increase of Japanese stocks. Taking Toyota as an example, in the fiscal year of 2023 (from April 2023 to March 2024), the depreciation of the yen is expected to increase profits by about 540 billion yen.Therefore, Morgan Stanley believes that in the scenario of a long-term weak yen, a stronger U.S. economy will continue to drive Japanese corporate performance driven by overseas demand, and corporate performance driven by external demand will outperform those related to domestic demand in Japan.
The yen exchange rate reaching 152 may be a turning point for the trend of Japanese stocks.
However, Morgan Stanley emphasizes in its report that if the yen depreciates beyond the exchange rate of 152 yen per U.S. dollar, it may turn into a negative factor for the Japanese stock market. If the exchange rate exceeds 157 yen per U.S. dollar, the increase in import prices due to yen depreciation may completely offset the actual wage growth.
The report states that excessive yen depreciation may have a negative impact on the Japanese economy and stock market through the following channels: (1) by suppressing consumption and having a negative impact on the real economy (households and small and medium-sized enterprises); (2) exacerbating the gap between enterprises and households, and between export-oriented enterprises and domestic demand-oriented enterprises, which is particularly disadvantageous for small and medium-sized enterprises; (3) reducing the U.S. dollar-denominated returns for overseas investors.
Firstly, we believe that the real economy will be negatively affected, as the rise in the prices of imported goods lowers the real income of households. Based on the sensitivity of import cost inflation to the U.S. dollar-yen exchange rate so far, we have calculated that 157 yen is the break-even exchange rate, meaning that the 3.7% basic wage increase decided by the spring wage negotiations is completely offset by import cost inflation (real wages do not increase). In other words, if the yen depreciates beyond the U.S. dollar-yen exchange rate of 157 yen, real income will not rise with the spring pay raise agreement, and may even decrease, which will severely drag down the Japanese economy and the Japanese stock market.
The second reason is the issue of the widening gap between enterprises and households, as well as among enterprises. Excessive yen depreciation is beneficial for export-oriented enterprises but disadvantageous for households, thus widening the gap between enterprises and households. We expect the negative impact on small and medium-sized enterprises to be particularly severe, as they account for 99.7% of the total number of enterprises in Japan and employ 70% of the workforce. Therefore, if the burden of excessive yen depreciation exacerbates the pressure for wage increases, it may drag down the overall economy.
The third reason is the decline in the U.S. dollar-denominated returns for overseas investors in the Japanese stock market. The market still expects the yen to appreciate (as of April 17, the market consensus expects the U.S. dollar-yen exchange rate to be 143 yen by the end of 2024), and we believe that most global investors will not invest in the Japanese stock market on the basis of currency hedging. The U.S. dollar-yen exchange rate was 140-150 yen when overseas investors heavily bought Japanese stocks in January-February. Due to yen depreciation, the U.S. dollar-denominated investment return rate has decreased by about 6%.
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