U.S. investors have had their financial thrill ride already set in motion for 2014, with U.S. equities taking a beating on global worries caused by emerging markets upheaval. For what it’s worth, it could be worse. Japan has seen its high-flying Nikkei stock index drop by 13% after a 52% surge in 2013.
Unlike a lot of the complicated webs of cause and effect that we see in modern finance, this one is a pretty classic example of straightforward economics. Concerns about global growth have sent U.S. investors from stocks into bonds, boosting debt prices and lowering yields. The U.S. 10-year Treasury has gone from near 3% to as low as 2.57%, although yields crept back up this week. The lower yields have taken the shine off the attractiveness of the U.S. dollar against low-yielding Japanese bonds, and depressed the value of the U.S. dollar against the yen from a high of 105 yen per dollar to lows nearer 100.
For Japan, this is significant. Being such an export-dependent country, Japan is very sensitive to a strong yen and it shows in Japanese stock prices. We saw that earlier this week when Toyota retained its title as world’s largest automaker by units sold. Toyota was boosted when the yen weakened in the last half of 2013.
It is particularly painful for Japan as they are running current account deficits - primarily related to higher imports of oil as they shift from nuclear power - after enjoying years of current account surpluses. Concerns about the value of the currency have boosted the correlation of the exchange rate to the Japanese stock market to a level three times higher than usual.
My View: This is a classic overshoot. The 52% rise in Japanese equities last year was too much, as is the drop so far this year. My colleagues at City National Rochdale continue to expect a normalization of U.S. 10-year yields to the 3.25-3.75% range; partly in response to the hope that the new government's expansionist fiscal and monetary policies will stimulate the moribund economy. Japanese equities were due for a correction, and just as valuations were too high on the way up, they will overshoot on the downside as well. Japan is still in for a tough year, but this is a relatively small bump in the road.
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