Japan – beyond the carry trade

The yen is back in the spotlight. Its recent slide to a four-decade low against the US dollar has become more than a source of official discomfort. The coordinated intervention, in response, by Japan and the US was rare and symbolically important, but it has not yet changed the market narrative - the yen has reversed nearly a third of its post-intervention move. That said, it reminds us that the direction of the yen is not a one-way bet.

For much of the past 15 years, the yen carry trade looked almost too easy: borrow cheaply in yen and buy higher-yielding assets overseas, often US Treasuries. The fear is that a decisive reversal, a sudden yen appreciation – perhaps as a consequence of intervention, sentiment or monetary normalisation – could force that trade to reverse abruptly, with implications beyond FX markets and into global bond and equity portfolios.

Why the worry? Japan’s international balance sheet is big: overseas assets of Japanese financial institutions are close to an estimated $7 trillion (USD). But those large overseas asset holdings are not necessarily leveraged yen-funded carry trades, which would be more immediately exposed to a sharp currency reversal. Although Japanese investors are slowly beginning to question the wisdom of holding so much of their savings abroad, the key questions are how much capital is repatriated and how quickly. Longer-term capital allocation decisions will be shaped by a host of factors, not least the relative opportunity set.

Even if the yen does not become a systemically destabilising force, there is an important fundamental point: the economic conditions that warranted a weaker yen seem to have disappeared.

Japan has long marched to a different cyclical beat from the rest of the developed world. But after decades of lacklustre economic performance, the old low-growth, low-inflation regime may finally be drawing to a close. Inflation has hovered around 2% for much of the past four years, and growth appears to be heading in a more favourable direction.

Business sentiment among large manufacturers is the highest since 2018, while sentiment among non-manufacturers is at its strongest in more than three decades. The improvement is likely being supported by the prospect of more supportive fiscal policy aimed at stimulating domestic demand, alongside longer-term aspirations to boost investment. More importantly, three successive Shunto wage rounds have left pay growing at close to 5%, firmly ahead of inflation. If that persists, rising real household incomes may finally contribute to more robust growth.

The corollary of this renewed activity momentum – and firmer inflation – is higher interest rates. Policy normalisation has been gradual, bordering on glacial, but expectations for quicker tightening are building. Money markets expect policy rates to nearly double, to 2%, by the end of 2027; longer-dated government bond yields have already moved to three-decade highs.

The improving economic story has also carried into the domestic stock market. Despite persistent currency weakness, which has dented returns when translated back to US dollars, the local stock market has managed to keep pace with the increasingly narrow global equity market over the past three years; both have annualised at close to 21.5% (with similar relative performance over five years).

But another important, overlooked development is a gradual shift in the way Japanese companies allocate capital. For decades, many firms accumulated cash, maintained cross-shareholdings, and prioritised balance-sheet resilience and stakeholder stability over profitability.

There are signs that reforms, which began under Abe’s Three Arrows back in 2014, are creating more shareholder friendly businesses. Companies are now paying more attention to capital efficiency – dividends and buybacks have risen – and boards are more independent. The Tokyo Stock Exchange’s challenge to companies trading below book value has proved a remarkably effective nudge in delivering higher equity valuations.

Profits are helping too. Consensus expects earnings growth of roughly 15% this year, with further similar gains pencilled in for 2026 and 2027. Some of this is currency related, which has supported Japan’s export-tilted market, but some of it is cyclical, with banks benefitting from rising interest rates, and industrial and technology segments benefitting from the global AI investment boom.

Buybacks are also assisting the arithmetic, which is progress after decades in which overcapitalised balance sheets and low-return assets weighed on corporate returns. However, for Japan’s re-rating to endure, higher shareholder returns need to come increasingly from stronger underlying profitability, not simply better balance-sheet arithmetic. Return on equity (RoE) is no longer an alien concept in Japan, but despite these signs, improvements in underlying profitability trends are still unconvincing. Today, Japan’s RoE is still towards the bottom of the major developed markets and just over half the US figure.

Governance reform has made Japan Inc. more attractive, but it won’t matter until firmer nominal growth – stronger wages and faster revenue growth – translates into sustainably higher returns on capital. The sugar rush of yen weakness may obscure this key point.

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