Global Usually Swamps Local—Japan Edition

With the European Central Bank (ECB) now cutting rates while the Fed and Bank of England (BoE) hold … and the Reserve Bank of Australia supposedly putting more rate hikes on the table … divergent monetary policy is a hot topic. And the tone is universally negative, couching this as a risk investors will struggle to navigate. But in major developed nations and regions, global trends usually swamp local idiosyncrasies like diverging policy or data. Consider Japan, and we will show you what we mean.

If ever a nation diverged from global trends, it is Japan. Where US inflation started jumping in early 2021, Japan was in deflation until that September—by which point the US’s Consumer Price Index (CPI) inflation rate topped 5.0% y/y. US CPI topped out at 9.0% y/y in June 2002, with much of Europe topping out at higher rates later that year. Japan? A peak of just 4.4% y/y in January 2023. Since then, while Western policymakers have fretted inflation isn’t cooling fast enough, Japanese policymakers remained concerned inflation wasn’t sustainable enough to shake the long, deflationary, lost-decades malaise.

Parallel to that, while the Fed, BoE and ECB embarked on aggressive tightening campaigns, the Bank of Japan (BoJ) kept its policy rate negative until March 2024. It continues with quantitative easing bond purchases—and a de facto peg on 10-year Japanese Government Bond (JGB) yields to this day. Add in the yen’s generational weakness—counter to a strong dollar—and the government’s sporadic interventions, and you have a big island in the metaphoric as well as literal, geographic sense.

And yet, Japanese stocks aren’t treading a unique path. Yes, they are up just 6.0% in USD, compared to 15.5% for the S&P 500 and 12.4% for global stocks excluding Japan.^[i] But that relative weakness stems from currency conversions. In yen, the MSCI Japan Index is up 20.0% year to date.^[ii]

Correlations offer another way to see this. For those who purged Stats 101 from their brain at the earliest opportunity (we empathize), the correlation coefficient measures the directional relationship between two series. A correlation of -1.0 means the two items always diverge, 0 means no relationship, and 1.0 means they always move in lockstep.

As Exhibit 1 shows, over the past two decades, the MSCI Japan Index has a 0.60 correlation with the S&P 500 and 0.66 with world stocks outside Japan. This means Japan has historically moved with the US and the rest of the world much more often than not. Though not a 1.0 correlation, it is a significant relationship. And, it still holds! The correlations haven’t markedly weakened over time, including since all this mad price-and-policy divergence started since 2020’s end.

Exhibit 1: Japan’s Remarkably Steady Correlations

Source: FactSet, as of 6/26/2024. MSCI Japan, S&P 500 and MSCI World Ex. Japan Index price returns in local currencies, weekly, 6/25/2004 – 6/25/2024.

Yes, even with a unique inflation path, wildly divergent monetary policy and a weak currency that continues to flummox the government, Japanese stocks are moving with the rest of the world vastly more often than not. And we haven’t even considered Japan’s ongoing GDP slump!

So what gives? Simply, Japanese companies operate in a global marketplace. They source components from the rest of the world. They sell overseas. A lot. Global trends have a vast influence both on the price they pay and the revenues they receive, which are central to corporate earnings.

Local factors can influence this. If companies choose to borrow domestically, Japanese rates will matter to both supply of and demand for credit. Domestic regulations affect the ease of doing business, local taxes paid, expansion costs and the like. But domestic policy, whether fiscal, monetary or regulatory, doesn’t say much about demand for Japanese products and services in America, Europe or the rest of Asia. Nor does it have much influence on component supply and pricing—all those markets are global. Even energy markets, which are a sore spot in Japan given its import reliance and weak currency, are much more global.

Hence, for Japanese stocks’ direction, global trends will generally matter more. If the world overall is growing, it will help carry Japanese multinationals’ corporate earnings even as domestic demand falters intermittently. This is the story right now, as Japanese markets continue clocking new highs despite local economic weakness. The rest of the world is a tailwind pushing Japan along.

We can apply this logic to many of the latest headlines. Worried about upcoming elections’ impact on UK and French stocks? You can revisit our analysis here and here, but regardless, the rest of the world helps pull both. Ditto concerns about ECB and Fed divergence—global matters more than local. We saw it last year, with German stocks riding global tailwinds despite the domestic recession.

Domestic factors can matter a great deal to relative returns, which also hinge on things like a country’s sector, industry and style makeup. Japan illustrates that, too. Correlations tell you how often two places move together directionally, but they don’t speak to magnitude. Still, the lesson holds: Divergent things like monetary policy doesn’t automatically mean markets will diverge.