the yen vs Nikkei, does it work?

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The Nikkei has recently outperformed all of its relevant peers by a fairly wide margin. For example, since the end of October 2012, Japanse equities have returned some 30% more than their American counterparties in the S&P 500. That is, of course, measured in local currencies. Over the same period the yen has decreased almost 20% against the dollar, eating up a large chunk of that relative performance.

The obvious reason for this massive outperformance in local currency terms would be that a lower yen improves the competitiveness of the export-driven Japanse corporate sector, which leads to more sales and earnings from overseas. Although, I agree with the mechanics of this relationship, I also want to point out, in my first ever post, that this positive relationship between the weakening of the yen and the relative performance of the Nikkei should not be fully taken for granted.

This can be derived from the graph above. It shows the correlation (a measure of strength of a relationship) between the USDJPY and the relative performance of the Nikkei against the MSCI World Index (NKY/MSCI WORLD in the graph). Only in recent years has this correlation been strongly positive. So only since the last seven years or so, a weaker yen can be related to an outperformance of the Nikkei. But before that the relationship was far less pronounced and in the early ’90s it was even negative. In that period a falling yen could actually be associated with an underperformance of Japanese equities. Just to keep in mind.

That said, there is another interesting point to make on this subject. The relationship shown above is that of the simultanious movement of the USDJPY and that of the Nikkei against MSCI WORLD. The correlation between the change of the yen in one period and the relative performance of the Nikkei in that same period. There seems to be no evidence on any reliable forecasting power of the yen with respect to the relative performance of Japanse stocks. Thus, a lower yen does not necessarily mean a better performance of the Nikkei in the future. So if you are taking the yen into account whether to invest in Japanese equities or not, which is probably a wise thing to do, given the strong correlation in recent years, it is equally wise to make a forecast of the development of the Japanese currency first.

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