Chart of the month: August angst in the Japanese equity market

2024 started in the best possible way for the Japanese stock market, which saw long-awaited renewed interest from global investors. This positive sentiment was mainly driven by key regulatory reforms targeting its capital markets but also supported by favourable macroeconomic conditions: moderate inflation, a weaker yen, and ultra-low rates. However, those efforts were wiped out in one day. On 5 August, the Topix index of leading Japanese companies fell by 12%.

In the history of bad days on the equity market, this is a big outlier. To put it into context, we’ve looked at the last 24 years of price data across the G7 countries. We have only seen double digit falls on 10 days in the past 24 years across seven markets. That is 10 out of over 40,000 observations, implying the chance of seeing such a fall in any given market on any given day is around 0.03%.

What was the catalyst for such a sell-off? The conventional wisdom is that it was the collision of the carry trade (investors borrowing in yen for next to nothing and investing in higher yield securities overseas) and weak US employment data that triggered the volatility. As investors unwound positions in a hurry, the yen rallied rapidly, undermining Japanese equities for both fundamental and technical reasons.

However, since that day, Japanese equities have rebounded smartly. Our chart of the month highlights that such ‘bouncebackability’ is common when we’ve seen episodes of similar extreme distress in the past.

Since 2000, when a national stock index has fallen by more than 10% on a single day, the average price return over the subsequent month has historically been +10.5%. Moreover, in 80% of such cases, returns over the following month have been positive. As the table above shows, larger falls have been a prelude to larger – and more consistent – recoveries.

We know that the past is no guide to future performance, but we should at least be mindful of the precedent that unusually large falls in equity markets have often been followed by periods of unusual strength. The bounce in the Japanese market since 5 August is not an aberration, but actually fairly typical behaviour following such an epic rout.

At the time of the market falls we recognised this was an opportunity to increase some risk in our portfolios, but we choose to express this by reducing our duration exposure. With hindsight it would have been better to have bought Japanese equities. However, we remain concerned that a US soft landing might not be as smooth as global equities markets currently imply.

All data sourced from Bloomberg as at 4 September. Past performance is not a guide to the future.