Can Japanese stocks withstand the dual pressures of yen depreciation and rising yields?

Can Japanese stocks withstand the dual pressures of yen depreciation and rising yields?

J.P. Morgan’s latest Japan equity strategy report points out that, despite the complex situation of early elections, a weak yen, and a rise in long-term interest rates, Japanese stocks still have room to rise before the end of 2026.

The core conclusion is: As long as the USD/JPY exchange rate does not break above 165, and the 10-year Japanese Government Bond (JGB) yield remains below 3%, the upward trend in Japanese equities is unlikely to change.

In the short term, one should be on guard against the risk of a correction brought about by “critical point” breaches in exchange rates and interest rates, especially due to foreign capital outflows. But from a medium- to long-term perspective, improvements in corporate profitability, valuation recovery, and potential buying by domestic pension funds and other institutions will support the market.

If the market corrects due to non-fundamental factors, similar to what happened in the summer of 2024, the Nikkei Index around 48,000 points will be seen as an excellent buying opportunity.

The election outcome determines the short-term direction, bullish logic for year-end remains

Regarding the early Japanese election to be held on February 8, the market’s short-term reaction will highly depend on the result, but regardless of the outcome, expectations of fiscal stimulus and political stability point toward a year-end rally.

Baseline scenario (LDP wins an outright majority): The Nikkei Index may be flat or dip slightly after the election, but will subsequently rebound, with a target of 57,000 points by end-2026.Weak scenario (LDP does not win a majority): The market may initially fall to around 52,000 points due to uncertainty, but fiscal expansion policies such as consumption tax reductions will limit the decline, and it is expected to rebound to 55,000 points by year-end.Strong scenario (LDP wins a stable majority): If the LDP wins more than 244 seats, the Nikkei may immediately break above 56,000 points after the election and reach above 60,000 points by year-end.

Exchange rate critical point: 165 yen is the key threshold

Yen depreciation is a double-edged sword for Japanese stocks. While it can boost export corporate earnings, excessive depreciation will erode asset values for investors without currency hedges and hinder real wage growth.

Diminishing earnings effect: The overseas production ratio of Japanese companies has risen above 20%, and they are no longer aggressively repatriating overseas profits. This has led to the sensitivity (Beta) of operating profit to exchange rates dropping from 1.0x in FY2016 to the current 0.6x.Asset impairment risk: For dollar investors who have not hedged FX risk, yen depreciation directly shrinks the value of holdings (Beta = -1x). When the boost to earnings cannot offset the asset impairment losses caused by FX moves, foreign investors tend to sell off.Critical point calculation: J.P. Morgan calculates that 165 USD/JPY is the threshold where upward momentum in the market weakens. Further depreciation to 170 would intensify worries about the yen getting out of control, possibly causing a short-term correction. Moreover, if the exchange rate exceeds 165, Japan's target of positive real wage growth will become hard to achieve, thus undermining the logic for a domestic demand recovery.

Interest rate alert line: 3% yield on 10-year JGB

Rising interest rates pose pressure to Japan’s financial system and equity market valuations, especially significant for regional financial institutions.

Regional bank pressure: J.P. Morgan estimates that if the 10-year JGB yield enters the 3.0%-3.5% range, the capital adequacy ratio of Japan’s regional financial institutions could fall below the regulatory red line of 8%. This would force them to accelerate losses on bonds and sell stocks to supplement capital.Valuation comparison: Currently, the Tokyo Stock Exchange (TOPIX) dividend yield is about 2%, and total yield including buybacks exceeds 3%. Once the 10-year JGB yield breaks above 3%, the appeal of equities versus bonds will fall steeply, triggering a rebalancing in asset allocation.Policy response: It is expected that the Bank of Japan and Ministry of Finance would take action (such as pausing quantitative tightening (QT), resuming bond purchases (QE), or adjusting pension asset allocations) to avoid yields rapidly breaching the critical psychological line of 3%.

Capital flow: short-term foreign selling vs. mid-term domestic support

Capital flows are key to short-term market fluctuations, but also provide logic for medium- to long-term support.

Short-term risk: Rising rates could prompt regional banks to sell stocks, triggering follow-on foreign outflows. This negative feedback loop in capital flows is the main downside risk for the short-term market.Mid-term support: Japan's domestic institutional investors have tremendous potential for capital return. From end-2012 to end-2024, Japanese corporate pensions and public pensions have transferred 4 trillion yen and 147 trillion yen respectively into overseas securities. As domestic yields rise (e.g., 10-year JGB yields surpassing the corporate pension assumed return rate of 2.14%), these funds could return to JGBs and the Japanese stock market, acting as stabilizers.

Risk scenario simulation: If “dual pressure” runs out of control

J.P. Morgan performed quantitative forecasts for two scenarios:

  • Scenario 1 (moderate risk): USD/JPY at 160 by year-end, 10-year JGB yield at 2.5%. In this case, fiscal expansion and moderate earnings growth could bring the Nikkei Index to 54,000 points by year-end.
  • Scenario 2 (high risk): USD/JPY depreciates to 170, 10-year JGB yield rises to 3.5%. In this case, although depreciation adds about 5% to EPS, valuation contraction (lower P/E) and asset impairment effects will dominate. The Nikkei Index is expected to face about a 10% correction, falling to around 48,000 points.

Even if the high-risk scenario leads to a market correction, as long as structural positives like corporate reform and moderate inflation remain unchanged, the Nikkei Index around 48,000 points will be seen as an excellent buying opportunity.

 

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