Yen rally triggers de-hedge in Japanese stocks, but investors fear earnings fall

The yen’s recovery has prompted global investors to withdraw from currency hedges as they no longer expect the Japanese currency to fall sharply.

Expectations that the yen could strengthen further prompted strategists at JPMorgan Chase & Co., UBS Group AG and BNP Paribas Asset Management to recommend unwinding currency hedges in Japanese stocks, which have outperformed many of the region’s peers, as that would boost returns in dollar terms.

“The recommendation at this time is to invest in Japanese stocks without hedging currency risk to benefit from higher dollar-denominated returns from a potential strengthening yen,” said Wei Li, multi-asset quantitative portfolio manager at BNP Paribas Asset Management.

The change in security reflects a broader shift in views on the yen since the Bank of Japan raised interest rates in July. It’s a double-edged sword for stocks, with a stronger currency reflecting Japan’s improving economic situation but making stocks more expensive for foreign buyers and worsening the outlook for exporters’ earnings.

UBS strategist Nozomi Moriya prefers to invest in Japan without hedging against currency weakness after her firm raised its year-end yen forecast to 145 from 160 against the dollar. However, the Swiss bank downgraded Japanese shares to underweight in local currency terms, citing the risk the currency’s strength poses to earnings forecasts.

In dollar terms, the Topix rebounded from the Aug. 5 crash to hit a three-year high last week. It has since given up gains on concerns about slowing global growth. Its 7.1% gain year-to-date has outpaced the 5.4% gain in the regional benchmark MSCI AC Asia Pacific Excluding Japan Index. The Topix also beat the Hang Seng Index and South Korea’s Kospi.

Many long-only investors, who bet on stocks going up but not down, don’t hedge their foreign stock holdings. But the yen’s continued weakness in recent years has encouraged investors to buy Japanese stocks with that protection. The popularity of the strategy is reflected in the New York-listed WisdomTree Japan Hedged Equity ETF tripling in size in 2023.

But the WisdomTree ETF has seen outflows of $897 million since August this year, when the yen’s trajectory reversed course and reached a seven-month high thanks to the Bank of Japan’s hawkish policies. The JPMorgan BetaBuilders Japan ETF, a popular Japanese stock fund that doesn’t hedge the yen, has seen inflows of $687 million during the same period.

Not every analyst sees the yen’s moves as a key driver of earnings. Masashi Akutsu, chief Japan equities strategist at Bank of America Securities, says most of Japan’s earnings growth is now being driven by a company’s ability to raise prices in an inflationary environment, not by a weaker yen.

But strategists say there is a risk that the rapidly strengthening yen could undermine corporate profits, making some analysts extra cautious about stock investing decisions.

“I’d like to be selective in Japanese stocks, focusing on interesting longer-term themes like corporate governance reform beneficiaries and geopolitical plays,” said Charu Chanana, a Saxo Markets strategist in Singapore. “It’s a completely different world, where the near-term risk-reward is skewed towards a stronger yen and weaker Japanese stocks.”

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