(Bloomberg): The era in which the yen, which has hit its lowest level against the dollar in about 38 years since 1986, has been a driving force behind Japanese stocks is coming to an end.

The 30-day correlation between the Nikkei and the yen turned negative in June for the first time since February, but the divergence has widened as investors grow increasingly worried that a sustained decline in the yen will hurt the Japanese economy.

The continued depreciation of the yen is likely to have a negative impact on the Japanese economy, as it will lead to higher import costs for raw materials and energy, and there is a risk that higher prices will reduce consumer purchasing power.

One of the factors that has Japanese stock investors growing increasingly wary is the speculation that the government and the Bank of Japan may again intervene in the foreign exchange market in an attempt to prevent the yen from weakening too much. For many years, a weak yen has been viewed favorably in the Japanese stock market as a factor that boosts the earnings of exporting companies, but if the government intervenes, the yen’s value will become unstable, and this could then become a burden on the performance of exporting companies.

The weak yen is undoubtedly what pushed Toyota Motor Corporation, the top Japanese company by market capitalization, to a record high of 5.3529 trillion yen in the previous fiscal year (ending March 2024), and it also contributed greatly to the Nikkei average reaching an all-time high for the first time in over 30 years. However, the historic weakness of the yen has reduced the investment income of overseas investors who invest in dollars, and overseas investors have been selling Japanese stocks for five consecutive weeks.

The weak yen has helped the Nikkei average rise less than 4% this year in dollar terms, significantly underperforming the 15% gains in the S&P 500 and the 6% gains in the Hang Seng Index. “Investors are increasingly concerned about the negative impact of the weak yen on dollar and euro earnings, which is leading to further outflows,” said Amir Anvarzadeh, a strategist at Asymmetric Advisors in Hong Kong.

At its June monetary policy meeting, the Bank of Japan surprised the market by postponing plans to reduce its purchases of government bonds until July. Overnight index swaps (OIS), which reflect the outlook for monetary policy, are priced at 69% in which the policy interest rate will be raised by 10 basis points (bp, 1 bp = 0.01%) in July, but the absolute interest rate differential between Japan and the United States remains large.

“As long as the Bank of Japan continues to move at a snail’s pace and turn a blind eye to asset losses, the yen will continue to weaken,” said Anvarzadeh. “Future interest rate cuts from the U.S. Federal Reserve could help the yen, but he worries this could spread to regional currencies.”

Deteriorating sentiment

Some overseas investors are showing signs of declining appetite for Japanese stocks, with Britain’s Schroders downgrading its view on the country to “neutral,” blaming the weak currency for signs of weakening consumer and small business sentiment, it said in its latest investor note.

Meanwhile, several strategists, including those at BlackRock and Morgan Stanley, remain upbeat about Japan’s long-term prospects, citing rising wages and progress in corporate reforms. The Nikkei has risen more than 17% this year in yen terms, outperforming other major Asian markets. Rie Nishihara, chief Japan equity strategist at JPMorgan Securities, sees the Nikkei reaching 42,000 yen by the end of the year.

However, SMBC Nikko Securities’ Chief FX and Foreign Bond Strategist, Makoto Noji, sees the current situation of currency depreciation as a problem, and in a report dated the 27th, he pointed out that attention should be paid to the fact that a further weakening of the yen could nip in the bud the virtuous cycle of escaping deflation. “Considering that the cost of living is rising daily due to imported inflation, it is about time that the weakening of the yen can no longer be overlooked,” he said.

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