Japanese stocks plummet: Is it the ebb or a breather?

Today, as the Japanese stock market fell by more than 12% in a single day, marking the largest decline since "Black Monday" in 1987, the once "infinite glory" of Japanese stocks has completely wiped out this year's gains and turned from rise to fall.

We tend to view this as a market stress test under macro and micro coordination. From a macro perspective, we tend to see this as a prelude to a major macro narrative shift—from the mainstream expectation of "soft economic landing + loose policy" at the beginning of the year, to last week when the Bank of Japan's rate hike encountered concerns about "recession" in the United States, Japan has become the most contradictory major economy in the macro narrative; from a micro perspective, the previously prevalent low-volatility Carry Trade (such as shorting the yen and going long on Japanese stocks), rapidly unwound under the ignition of the Fed's pivot and the Bank of Japan's rate hike, bringing about stampedes and liquidity risks.

Although we do not currently believe this will prompt the Fed to change its pace of rate cuts, the performance of the Japanese market today undoubtedly serves as a "preventive needle" for central banks worldwide. In the event of economic recession risks, tight and hesitant policies will put enormous pressure on the market.

"Black Monday" has once again descended on overseas markets, leading to the collapse of leveraged trading in Japanese stocks. Today, the Nikkei index fell by 12.23%, marking the largest decline since October 20, 1987. The Asia-Pacific region and European and American stock markets all experienced varying degrees of decline, reminiscent of "Black Monday" in October 1987. The widespread liquidation of leveraged trading in Japanese stocks has accelerated the market's decline. Behind the continuous rise of Japanese stocks since the beginning of the year, leveraged trading has played a significant role, with leveraged funds' extreme bullish sentiment propelling the Nikkei to historic highs. In the recent downturn, many trades are facing forced liquidation.

Macro trading sees a "dramatic reversal," with carry trade liquidation triggering liquidity pressure. Trading strategies such as going long on US stocks/Japanese stocks and shorting the yen are undergoing significant reversals, especially as carry trades accelerate liquidation, sparking a market risk-off sentiment.

Among major asset classes performing well since the beginning of the year are: US stocks, Japanese stocks, gold, and copper; while weaker performers include: the yen and the renminbi. However, from July 22 to August 2, except for gold, most major asset classes that had performed well previously have experienced significant adjustments: the Nikkei 225 index fell by 20.6%, the S&P 500 fell by 3.9%, and copper fell by 1.6%; whereas previously weaker assets have performed relatively well: the yen rose by 4.3%, and the renminbi rose by 0.81%.

The strong rise of currencies such as the yen is due to the accelerated liquidation of large-scale carry trades in the foreign exchange market. The basis swaps for the yen and the euro relative to the dollar have widened, reflecting a marginal increase in global market liquidity pressure

Concerns about the US economic recession are the key trigger for the reversal. Last week, both the July ISM PMI and non-farm payroll data in the United States fell short of market expectations, sparking concerns about a US economic recession. Whether it is the S&P 500 index dominated by large blue chips or the Russell 2000 index dominated by small and medium-sized companies, both experienced varying degrees of decline after the data was released.

During the Asian trading session on August 5th, the selling in the Asia-Pacific stock markets also led to a sharp drop in US stock index futures. In a situation where there is no fundamental data support, CME futures pricing for a 50 basis point rate cut by the Fed in September increased from 22% on Friday to 95%, indicating that market participants are urgently calling for a rapid rate cut by the Fed to avoid the risk of an economic hard landing.

Buffett's selling has intensified the market's risk-off sentiment. In addition to economic fundamentals, changes in the behavior of important market participants have triggered a certain amount of herd mentality. Berkshire Hathaway, under Buffett's leadership, significantly reduced its holdings of Apple Inc. shares from 789 million shares in the first quarter to about 400 million shares in the second quarter, a decrease of nearly 50%. Considering the current high position of the US stock market and Buffett's market indicator role, this has intensified market participants' risk-off sentiment.

Why did the Japanese stock market experience the biggest decline? Three factors have destined it to be the weakest link globally.

Firstly, there is pressure on the denominator end. The Bank of Japan raised interest rates twice in April and July, while also starting Tapering, leading to a tightening monetary policy cycle that inherently restricts the performance of risky assets such as stocks.

Secondly, there are concerns on the numerator end. Global manufacturing PMI has peaked and fallen back, the US economy is weakening, as a typical export-oriented economy with companies with high overseas revenue weighting in the index, there are also hidden concerns on the numerator end.

Thirdly, risk aversion sentiment is spreading. On one hand, pessimistic expectations of a US economic hard landing are still spreading in global markets; on the other hand, there are signs of further escalation in conflicts in the Middle East. Once oil prices surge significantly due to geopolitical factors, the pressure of input inflation on the Japanese economy will be significant, increasing the likelihood of investors choosing to exit.

Regarding the most concerning issues in the market currently, how will policies respond overseas, will the Fed cut rates early? Domestically, what impact will domestic assets face?

For the former, we tend to believe that faced with extreme market volatility, relevant overseas government departments will intervene promptly, but the likelihood of intervention by Japanese authorities is higher than that of the Fed at the moment, and the measures taken are more likely to be liquidity injections rather than rate cuts.

For the latter, we believe that the impact on A-shares will be relatively limited, especially against the backdrop of low foreign holdings, strict supervision of margin trading and securities lending, and quantitative trading; while the RMB may experience short-term overvaluation, especially with the need to be vigilant against a surge in foreign exchange demand, exchange rate stability may require official intervention (either Japan or China) Of course, the Renminbi still faces uncertainty in the medium to long term.

Author of this article: Tao Chuan (S0600520050002), Wu Bin, Source: Chuan Yue Global Macro, Original Title: "Japanese Stocks Plunge: Is it the ebb or a breather? (Minsheng Macro Tao Chuan, Wu Bin)"