All eyes have been on Japan recently, with the economy displaying the kind of volatility that leaves analysts glued to the edge of their seats!
For the first half of this year, Japan’s economy was flourishing. The Topix index saw an all-time high around three weeks ago, driven by increased interest from international investors. However, it didn’t take long for things to head south.
On the 5th of August, the Japanese benchmark index, the Nikkei 225 Index, plummeted by 12.4 percent – its worst day since 1987. On this day, the index lost all of its year-to-date gains – causing a rather dramatic-looking price chart. But, in a rather dramatic turn of events, the index shot back up by 11 percent on the 6th of August. Just one day after.
When the index plummeted, European and US markets followed suit. The S&P 500 saw a loss of three percent, the Nasdaq was down 3.4 percent, and the UK’s FTSE 100 dropped by two percent.
As you can imagine, the market’s performance on the 5th of August caused worldwide panic among investors. It seemed like everything was plummeting at once – as if Japan was the first domino to fall.
But, why does the Japanese economy have such a big impact on global markets and should this be something to worry about?
The rise of Yen ‘carry-trade’
Behind the scenes of Japan’s flourishing economy has been the rise of a Yen ‘carry-trade’. Carry trading is a strategy whereby investors borrow an asset with a low interest rate and then reinvest it into an asset that provides a higher rate of return.
For example, you might use a credit card with zero percent interest period to buy a financial instrument that yields a five percent return. Once you pay back the money that you borrowed from the credit card you would be left with the return as a profit.
For a long time, interest rates on the Yen have been low compared to the US dollar, the Euro and the Pound.
Therefore, the currency attracted carry traders from around the globe who use borrowed Yen to invest in higher-yielding assets, such as the US dollar.
For the first half of the year, Japan’s suitability for carry trading led to increased interest from international investors, which drove growth in the stock market.
However, shortly before the Topix index plummeted, the Bank of Japan decided to raise interest rates on the Yen to the highest level since 2008.
This saw the Yen rally but caused the Topix to plummet as investors headed for the exit. When interest rates go up, carry trading becomes less profitable and more risky!
Will the panic continue?
Despite the initial panic, it seems like the Bank of Japan is rethinking its decision. On the 7th of August, The Bank of Japan’s Deputy Gov. Shinichi Uchida declared a halt on interest rate hikes whilst the market is unstable.
This caused Japanese shares to reclaim some of their losses, with the Topix closing 2.3 percent higher on Wednesday.
However, I still think that we are in dangerous waters!
Although market watchers have attempted to make sense of the stock market’s movement over the last few days, a lot still seems very unclear.
On top of this are growing fears of a US recession that have caused US stocks to take a fall. So, even if Japanese markets recover, I think it could be some time before global markets calm down!
Over in the UK, the FTSE 100 jumped 1.75 percent upon hearing that Japan will pause interest rate hikes. A similar movement was seen in European markets including Germany and France.
The BoJ’s decision to pause interest hikes seems to have calmed the nerves of carry traders who have resumed shorting the Yen to invest in higher-yielding assets.
If I’ve learned anything from the past week, it’s that the Japanese economy has a big hold over the performance of major stock markets including the US and the UK. So, if I were an investor, I would keep a sharp eye on future decisions made by the BoJ!
As always, last week’s turbulence proves that diversification is key when it comes to investing. By spreading your investments across various markets, you can minimize the impact of big losses.
To learn more about this, check out our helpful guide on the importance of holding a diverse portfolio at MoneyMagpie.com.
Jasmine Birtles is the founder of MoneyMagpie.com. Get insider secrets for clever investing by signing up to their free, fortnightly investing newsletter here.
