Ongoing weakness in the Japanese yen is raising significant concerns among investors that the currency's sustained depreciation could eventually erode a key driver behind Japan's stock market rally—foreign capital inflows.
At first glance, data from overseas-listed exchange-traded funds (ETFs) suggests robust international demand for Japanese equities. Compiled figures indicate that in recent years, ETFs investing in the Japanese stock market on an unhedged basis have seen a steady increase in appeal, with cumulative net inflows reaching $47 billion. In contrast, products employing currency hedging have experienced capital outflows.
However, strategists warn this dynamic could shift rapidly. Pension funds and long-only asset managers typically do not hedge currency risk, making their investment returns increasingly vulnerable as the yen weakens further. The market is now questioning how much lower the yen must fall before currency losses overshadow the appeal of Japanese stocks themselves.
Richard Kaye, Co-Head of Japanese Equity Strategy at Comgest Asset Management in France, stated, "Currency risk is one of the core concerns currently facing Japanese equities." While Japan remains an important destination for global investors seeking exposure to AI-related themes outside the United States, the persistent yen depreciation is becoming increasingly difficult for those largely unhedged against currency fluctuations to ignore.
Year-to-date, the Topix index has surged 19%, reaching fresh all-time highs. However, when measured in U.S. dollar terms, these gains narrow to approximately 14%, as the yen has weakened past the 163 mark against the dollar, hitting its lowest level since 1986. Widening interest rate differentials and concerns over Japan's fiscal outlook are the primary factors weighing on the yen.
The rising influence of overseas investors is amplifying the impact of currency effects. Exchange data reveals that as of the end of March, foreign holdings of Japanese stocks reached a record 34.7%, up from 30.2% five years prior. Since Sanae Takaichi won the Liberal Democratic Party's presidential election and became Prime Minister last October, overseas funds have accumulated net purchases of over 12 trillion yen (approximately $74 billion) in Japanese spot stocks.
The composition of this foreign capital also differs markedly from the past. Yoshitake Suda, Senior Cross-Asset Strategist at Nomura in Singapore, pointed out that during the early stages of former Prime Minister Shinzo Abe's administration, foreign inflows were primarily driven by short-term capital, which typically hedged currency risk. The current rally, however, is being led by long-term investors like pension funds, which often do not employ currency hedging.
"From a capital flow perspective, the positive impact of yen depreciation on Japanese stocks is no longer as clear-cut as it once was," Suda said.
Of course, a weaker yen continues to support the earnings of export-oriented companies. Professional estimates suggest that if the yen remains at its current low levels, Japan's major automakers could collectively see an additional 900 billion yen in extra profits.
Nevertheless, Kazunori Tatebe, Chief Strategist at Daiwa Asset Management, noted, "With the yen falling to historic lows, the market broadly believes its depreciation trend shows no signs of stopping. This could prompt unhedged investors to pause their buying until the currency stabilizes."
In summary, the yen's decline has transitioned from a "clear positive" for Japanese stocks into a "double-edged sword." While it boosts export profits, it simultaneously erodes the real returns for unhedged overseas capital, potentially undermining a critical foundation of the current bull market.
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