Japanese stocks plummeted, UBS: Buying now is like catching a "falling knife"!

Japanese stocks continued to plummet on Monday, with the Nikkei 225 and TOPIX indices both entering bear market territory. Kelvin Tay, Chief Investment Officer for UBS Global Wealth Management in the region, warned that entering the Japanese market at this time is like catching a "falling knife."

Tay stated: "The only reason Japanese stocks have been strong in the past two years is because the Japanese yen has been very, very weak. Once the situation reverses, you have to get out immediately and I think that's what everyone is doing now."

The yen-dollar exchange rate fell to a 38-year low of 161.99 in June, but reversed course before the Bank of Japan policy meeting. The Bank of Japan raised its benchmark interest rate to around 0.25% last week and decided to reduce its purchases of Japanese government bonds, leading to a further appreciation of the yen.

On Monday, the yen-dollar exchange rate surged by over 2%, reaching its highest level since January. The strengthening yen has put pressure on Japanese stocks, as the market is largely dominated by trading companies and export-oriented enterprises, whose competitiveness is eroded by the yen's appreciation.

Bank of Japan Governor Haruhiko Kuroda made hawkish comments at a press conference after the July 31 meeting: "If the economy and prices continue to follow our forecasts, we will continue to raise interest rates."

He also mentioned that the policy rate still has a "considerable distance" to reach a neutral level that neither cools nor overheats the economy. Kuroda stated that a 0.5% interest rate level (unseen in Japan since 2008) is not a barrier, and rates could even go higher.

Tay believes that the yen's movement can indicate the performance of Japanese stocks. As the yen strengthens, stocks fall, "Unfortunately, Japanese stocks still face greater pressure," he said.

While Tay acknowledges that some of the stock market gains are due to restructuring efforts by the Tokyo Stock Exchange, the "main driving force is the yen".

One factor in the yen's importance in Japanese stocks is the unwinding of so-called "carry trades."

When the yen is weak and the Bank of Japan sets rates at zero or negative, investors borrow yen at low rates and invest the funds in higher-yielding assets. Using the central bank's benchmark rate as a reference, investors could borrow yen at 0% at the beginning of the year and invest in the U.S., earning 5.25% interest.

Now, with the Fed hinting at rate cuts on the horizon and the Bank of Japan further raising rates, the interest rate differential between the two central banks will narrow, making "carry trades" less attractive and potentially paving the way for further yen strength.

Tay expects the yen-dollar exchange rate to reach around 143 (near current trading levels), but if Japanese life insurance companies and pension funds start repatriating more yen to Japan, the currency pair could rise to 135 dollars.

He said: "Indeed, the yen will stabilize at a certain level, but at the current time, Japanese stocks still do not have enough appeal for me to really want to enter."