Rotation into Japanese stocks

Is Japan looking toppy? Rotation into Japanese Stocks.

Earlier this week, the TOPIX index reached its highest level since August 1990, while the Nikkei surpassed the 30,000 marks for the first time since September 2021. Recent concerns about the growth outlook in the US and Europe have led to a noticeable shift in investor sentiment towards Japanese stocks. This shift comes at a time when the Japanese economy is recovering from its long-standing deflationary spiral, supported by accommodative monetary policies. Additionally, the renowned investor Warren Buffet has increased his stake in Japanese stocks, making Japan his second-largest country holding after the US. Foreign investors have also been actively purchasing Japanese equities, with seven consecutive weeks of buying, resulting in a year-to-date investment of ¥3.2 trillion, the highest since the introduction of Abenomics in 2013.

Looking ahead from a medium to long-term perspective, I maintain the belief that Japan remains one of the most favourable regional equity markets. The Japanese economy is undergoing a significant structural transformation, with corporations expected to gain increasing pricing power. Furthermore, the prospect of higher wage growth is likely to sustain the domestic growth trajectory. However, in the near term, recent flow trends suggest a possible pause in the momentum of Japanese equities, particularly as we approach the June policy meeting of the Bank of Japan (BoJ). Economists from JP Morgan anticipate a high likelihood of an announcement regarding the adjustment or even abandonment of Yield Curve Control (YCC) during this meeting.

Data from my Japanese quantitative strategy indicates that the recent robust rally in the Nikkei/TOPIX has been primarily driven by increased buying from systematic funds. This raises a near-term risk to the market as these funds may now pose a potential threat. According to their estimates, the net exposure to Japanese equities among recognized systematic funds (including CTAs, trend-following funds, risk-parity, and other risk-control funds) is currently at a level comparable to the second half of 2021.

While solid corporate results and positive earnings guidance have contributed to buying in recent weeks, I’m concerned that the positioning levels among systematic investors may have become "irrational." Even a minor shock could trigger a significant unwind, potentially causing the Nikkei to decline to 27,600. It is essential to monitor the market closely, particularly given the potential impact of these factors on the Japanese equities landscape.

Figure 1: CTA’s position on TOPIX futures

Figure 2: Systematic funds’ (CTAs, risk-parity) net exposure to Japan equities