Pressure on the yen and the yuan
We believe active management can identify companies with a strong competitive edge, especially in technology, and those with stronger pricing power internationally.
Chief Market Strategist, Asia Pacific
- The Japanese yen (JPY) and the Chinese yuan (CNY) have both come under pressure due to rising U.S. interest rates.
- Japanese equities have not benefited from a weaker yen, but we believe active management can identify companies with pricing power and an international competitive edge.
- For China, the top priority would be to contain the latest round of COVID-19 outbreak and put economic growth back on track. This would attract some investors back into the market given undemanding valuations.
JPY pressured by a dovish BoJ and more expensive fuel imports
The JPY has weakened against the U.S. dollar (USD) by over 11% since the start of the year to its weakest since 2002. We believe this is primarily brought upon by the relative policy stance between the U.S. Federal Reserve (Fed) and the Bank of Japan (BoJ). The Fed is set to tighten its monetary policy at an aggressive pace in coming months. The market is currently pricing in 50bps policy rate increase in each of the next three Federal Open Market Committee meetings in May, June and July. On the other hand, the BoJ is still firmly defending the 10-year Japanese government bond yield upper limit of 25bps.
We expect the BoJ to maintain its loose monetary policy stance. Even though Japan’s headline inflation could rise towards the central bank’s target of 2% in 2022, it could see this inflation as temporary driven by food and energy prices, and not from domestic demand. This view is well justified given that the Japanese economy is just starting to emerge from the pandemic.
In addition to the interest rate differential, the Japanese current account could also come under pressure given the rise in commodity prices, especially crude oil and natural gas. In the first two months of 2022, Japanese imports of petroleum rose 9% in volume, but 83% in value, compared with a year ago. Meanwhile, its import volume of natural gas declined by 13% during the same period, but the import value rose 56%. Its goods and services component of the current account has been in deficit for 10 of the last 11 months.
The combination of differences in monetary policy and the negative impact on Japan’s current account could continue to put pressure on the JPY in the near term. It remains to be seen whether the Japanese authorities would step in to stabilize its exchange rate, but it does not look likely for now.
The latest outbreak is hitting the CNY
The CNY has appreciated against the USD since mid-2020, aided by its economic recovery, robust export performance and capital inflow. It maintained its strength even in 1Q 2022, when the Fed started to prepare the market for monetary tightening. However, the CNY weakened against the USD by 3.2% since late March.
The current outbreak of COVID-19 in China has brought the CNY’s weakness via two channels. First, investors remain very cautious on China’s near term economic growth outlook, which weighs on domestic asset prices. It is understandable that economic stimulus may need to wait for the lockdown to be over to take full effect. This prospects for near term earnings volatility has triggered outflow from A-share market. Hence, we see a decline in daily new infection numbers to be one of the first conditions for investors to be more upbeat.
Second, the People’s Bank of China is expected to loosen monetary policy further to support the economy, even though the measures adopted so far have been less aggressive than expected. The start of the CNY depreciation against the USD came after the 2-year U.S. Treasury (UST) yield rose above its Chinese government bond (Exhibit 1).
In contrast with Japan, China’s trade balance is still robust, despite possible short-term disruptions on supply chain. China’s current account surplus grew by 39.5% in 1Q 2022, compared with a year ago. This should provide some buffer to the CNY. The Chinese authorities could also be mindful to prevent excessive currency depreciation to prevent further stress on Chinese companies with USD liabilities. The reduction of the required reserve ratio for FX deposits from 9% to 8% can be seen as a measure to tame the depreciation.
The upside risk to UST yields could still put depreciation pressure on JPY and CNY in the near term. For Japan, its equity market has failed to respond positively to a weaker JPY in the past year, which should make Japanese exports more competitive and improve Japanese corporate earnings from overseas when translated back into local currency. This could be because of the rising input costs associated with global inflation. Nonetheless, we believe active management can identify companies with a strong competitive edge, especially in technology, and those with stronger pricing power internationally.
For China, the top priority would be to contain the current round of outbreak and place the economic growth back on track. Combined with economic stimulus, this should attract investors back to the market considering the undemanding valuation of Chinese equities, both onshore and offshore. Capital inflow should also help to stabilize the currency.