Stock Investors Fearing Fed Should Consider Fleeing to Tokyo

  • Topix outperformed U.S., Asian shares during past Fed hikes
  • Exporters Toyota, Fuji Heavy among stocks to watch: SuMi Trust

Examining the Unknowns of a Federal Reserve Rate Hike

The safest place for stock investors when the Federal Reserve raises interest rates may be half a world away in Tokyo.

That’s because the Topix index has outperformed U.S. shares during Federal Reserve tightening cycles going back to 1988. The Japanese gauge’s average rally over the last four periods of higher rates is almost twice as much as the advance for the Standard & Poor’s 500 Index and beat a gauge of Asian stocks excluding Japan. The Topix also showed an average gain in the month after the initial rate move for each cycle, while U.S. and Asian indexes fell.

The Fed’s first interest rate increase in almost a decade is expected this week after Chair Janet Yellen signaled the U.S. economy is ready for higher borrowing costs. Equities are sliding around the world amid heightened concern the central bank is tightening at the same time plunging commodity prices signal a deterioration in global growth. A Fed rate rise is good news for Japanese stocks, say analysts, as it should translate into improved prospects for exports as the dollar climbs versus the yen.

“When the U.S. raises interest rates, it’s because its economy is strong, which means export growth for Japan,” said Kenji Abe, head of Japan equity strategy at Bank of America Corp.’s Merrill Lynch in Tokyo. “It also weakens the yen, and that means Japan sees double the benefit.”

While tumbling oil and slowing growth in China have battered global stocks, with the MSCI All-Country World Index sliding the most last week since early September, the Japanese market has held up better than its peers. The Topix is the fifth best performing developed market in 2015 as Bank of Japan monetary easing weakened the yen and boosted profits to a record.

The yen, meanwhile, is expected to further depreciate through to the middle of next year, even after its steepest losing streak on record. Banks forecast the Japanese currency to weaken more than 1.5 percent to about 124 yen per dollar by the second quarter of 2016, while wagers on dollar strength versus eight peers rose to the highest in three months in November.

The past performance of Japanese equities when the Fed increases borrowing costs supports optimism. The Topix index averaged a gain of 14 percent over the course of four tightening periods that began in 1988, 1994, 1999 and 2004. The S&P 500 rose 7.8 percent over the same time spans, while the MSCI Asia ex-Japan gauge climbed 12 percent.

The initial market reaction to a Fed move also favored Japan. In the month following the first rate increase, the Topix added an average 1 percent, while the U.S. index fell 1.7 percent and the Asian measure lost 2 percent.

Traders are seeing a 76 percent chance the Fed will raise rates for the first time since 2006 after their meeting on Dec. 16, up from 66 percent a month ago. The latest U.S. payrolls report showed employers added more jobs in November than expected, and gross domestic product rose at a faster pace in the third quarter than previously reported as consumers continued to power the economy.

Japanese exporters such as Toyota Motor Corp. and Fuji Heavy Industries Ltd. are among stocks to watch in 2016 as beneficiaries of improved economic conditions in the U.S., says Genzo Kimura, an economist at Sumitomo Mitsui Trust Holdings Inc.

“One of the biggest challenges for the world economy in 2016 will be figuring out how to muddle through an environment of high interest rates,” Kimura said.

Not all of the four Fed tightening periods were successes for Japan stocks: the Topix fell during the 1994 cycle, dropping 9.3 percent, while the S&P 500 was little changed. And certainly, investors would have been better off holding U.S. shares through the entire span from 1988 to the present, considering the Topix is 47 percent below its 1989 peak while the S&P 500 has gained 486 percent.

Risky Timing

It’s risky for Yellen to raise rates when oil prices are tumbling, and will lead to a selloff in emerging market currencies, says Mitsushige Akino, executive officer at Ichiyoshi Asset Management Co. in Tokyo. This could mean more competition for Japanese exporters while the yen will gain as demand for a safe haven increases.

“There’s a 50-50 chance that Japanese stocks will fall after the Federal Reserve raises rates,” Akino said.

The Topix lost 1.7 percent at the close in Tokyo on Tuesday, while the yen traded 0.2 percent higher at 120.79 per dollar.

Others say that given the recent turmoil in global financial markets, Japan is a safer bet. The Tankan index of confidence among big manufacturers unexpectedly held up in the past few months, data released Monday showed, suggesting that record profits are compensating for uncertainty about the effects of a rate increase and slowdown in China.

“The Japanese market has generally been among the best performers” during Fed tightening periods, Eiji Kinouchi, chief technical analyst at Daiwa Securities Group Inc., wrote in a report. Japan could “attract particularly strong buying interest among major markets. Our eyes are on the Japanese market.”

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