Japanese equities could outperform this year
The much anticipated decision from the Bank of Japan, which increased interest rates rise from 0.25% to 0.5%, saw Japanese equities move sharply higher for most of the month as investors considered the move a vote of confidence from the central bank in Japan’s economy. The decision followed news that annualised fourth quarter Gross Domestic Product hit 4.8% against a forecast of 3.8%. Corporate results were also positive during the month, as retailers gained on hopes that a stronger economy would boost consumer spending. Over the month, the Topix index rose 1.8%, although much of the earlier positive performance was wiped out at the end of the month by the concerns centring on other Asian equity markets.
Whilst there isn’t enough evidence to prove conclusively that the unwinding of the Yen carry trade is a major cause behind the turmoil in markets, the perception of its significance to investors is apparent. Investors that borrowed cheaply in Yen (due to the low interest rate) to invest in higher yielding positions elsewhere, have now been settling their positions due to the strengthening of its currency. This has been cited as a key reason behind the sell-off in global equities, including Japan. Once this trend decouples, i.e. markets no longer react to movements in the Yen, risk aversion is likely to settle. Meanwhile as private consumption grows, the Bank Of Japan is likely to stay under pressure to raise interest rates. Last month the BOJ raised interest rates to 0.5%, but noted that this would not be followed by consecutive
moves to raise borrowing costs. Japan currently has the lowest interest rates among industrialized nations, and the government has been pressuring the central bank to keep rates low so as to not endanger the economic recovery. While the performance of Japanese equities in 2006 and at the start of 2007 has been disappointing, economic expansion has remained solid. As such, Japanese equities could outperform this year. Within equities, small caps underperformed in 2006, and may have significant potential upside.
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