Investment managers attributed a “constructive” outlook for Japanese stocks amid heightened investor anxiety following the market’s double-digit declines in early August.

Buoyed by macro and systemic trade amid fears of a US recession, the Bank of Japan’s (BOJ) surprise decision to raise interest rates and the yen’s rapid appreciation, Japanese stocks experienced their worst trading day in nearly four decades on Aug. 5, as Japan’s Nikkei 225 stock index lost more than 12 percent in a single day.

The market lost a cumulative about 1.1 trillion US dollars in a three-day sell-off as investors began to worry that the yen’s rapid rise would cut into profits for Japanese export-oriented companies.

Allocations to Japanese stocks suffered their biggest one-month decline since April 2016, according to Bank of America's latest survey of global fund managers. since, dropping from a net 7 percent overweight to a net 9 percent underweight.

These allocations are now at their lowest point since May 2023.

Analysts at Templeton Global Equity Group, part of Franklin Templeton, believe this market reaction is "extreme."

"Unless one thinks the US economy is in for a hard landing, the level of sell-off in Japanese stocks appears unwarranted," they said in a market note.

"We expect market volatility to persist in the short-term amid the ongoing debate surrounding the US outlook and the uncertainty caused by the yen's carry trade fallout." However, our main view is still a soft landing for the US economy. Against this backdrop, Japanese equities should continue to provide long-term value, especially for fundamental stock markets.”

Analysts opined that the fundamental picture for this market remains unchanged, with Japan's structural return on equity (ROE) improvement story still intact.

In addition, the economy is normalizing after three decades of deflation, they pointed out, and corporate reforms have become mainstream.

"These unique opportunities are underrepresented at the stock index level," the analysts said, noting that they would benefit from "mispricing" resulting from volatility.

Speaking to InvestorDaily, Betashares investment strategist Hugh Lam also noted that the sharp sell-off earlier this month had "caused a lot of volatility and uncertainty about the future trajectory of Japanese stocks". However, he believes the overall outlook remains positive in the medium to long term.

He also cited a number of factors driving his optimism, including shareholder-friendly buyback and dividend reforms; strong corporate balance sheets demonstrating low debt and high cash levels; and attractive valuations compared to the US.

"Japanese stocks compared to US stocks are attractively priced," he told InvestorDaily.

"They're trading at about 15 times earnings, which is significantly less than the US, and when you factor in the earnings growth they're expected to generate over the next year — about 10 percent — that's actually a pretty good payout."

Also covering the selloff, Daniel Hurley, global equity portfolio specialist at T. Rowe Price, described the correction as "excessive."

In a market note, he said this may instead be a good time to "selectively add" to Japanese stocks, particularly names with less exposure to the U.S. economy and yen strength.

"Looking ahead, domestically, we are keeping a close eye on inflation, particularly wage inflation figures, as these will be the key determinant for the Bank of Japan to confirm that the economy is free from 30 years of inflation," he explained Hurley.

“Broader domestic data looks healthy in terms of GDP growth and consumption [and] a stronger yen should offer further relief to domestic consumers as it lowers the cost of food and energy imports.

A reason for caution

However, Joe Unwin, head of portfolio management at Apostle Funds Management, offered a slightly different view, noting that the selloff "doesn't look that excessive" compared to the Japanese yen's recent rally.

The Japanese currency rose 8% against the dollar in the three weeks to August 1 to 149.2 per dollar, threatening to undo the carry investment strategy. The yen is currently 147.2 to the dollar.

"It's a significant drop in earnings expectations that justifies the sell-off in Japanese stocks," Unwin told InvestorDaily.

"Investors should note that Japan was one of the best performing equity markets over the past 6-12 months prior to the sell-off, so there was plenty of room to fall."

In light of this, he urged caution on the Japanese market as the yen's rally maintains momentum.

"Major financial institutions suggest that unwinding of the yen carry trade is still underway, suggesting that the yen may continue to be supported by excessive buying volume by traders," he said.

"Furthermore, the BOJ has been making persistent attempts to support the yen, suggesting that the decline could be limited through regulatory intervention."

According to Unwin, the yen's strengthening against the US dollar will prove to be a key headwind going forward.

Although the yen has risen about 10 percent in the past month, it began that rally from a historic low, Unwin pointed out, and remains 30 percent lower than it was three years ago.

"So there's a lot of upside," he said.

"Over the past 25 years, Japanese stocks have underperformed U.S. stocks by about 7 percent annually on average during periods when the yen has strengthened against the U.S. dollar."