The UK’s surprising Brexit referendum outcome reverberated through the Japanese stock market, causing a nearly 8% drop in the Nikkei 225 index in the aftermath
Since then the stock market has recouped more than half the losses, but the vote continues to produce effects via other transmission channels. Of these, the exchange rate is the most important. The JPY:USD exchange rate appreciated due to, on the one hand, the global flight to safety from risky assets and, on the other hand, the expected flattening of the Federal Reserve interest rate trajectory (which lowers the expected returns from investing in USD-denominated assets). We have lowered our Yen exchange rate forecast to JPY107:USD for 2016 (from JPY111:USD previously), and now predict an exchange rate of JPY102:USD in 2018 (instead of JPY110:USD). The inflation rate outlook has also been revised downwards, reducing Japan’s prospects of exiting the deflation trap.
While the Brexit-related uncertainty will mainly have an indirect impact on the Japanese economy (exports to the UK are less than 2.0% of Japan’s total exports, and those to the EU less than 8.0%), this impact will be moderate rather than negligible.
Positive Implications
Companies can expect input prices to stagnate, as both domestic inflation and imported inflation will remain low. The payments performance of Japanese SMEs may improve, as they rely to a large extent on imports and sell domestically, hence benefitting from the stronger Yen.
Negative Implications
With inflation under pressure from the strong Yen, Japan will not exit the deflation trap in 2016 either, with negative impact on the country’s long-term growth prospects. Corporate profits will be lower than was anticipated before the vote (the repatriation of foreign profits will translate into lower Yen-denominated profits) while exporters in general will struggle due to their poorer price competitiveness. Automakers are particularly affected. The 1,000 or so Japanese companies active in the UK (some of which export from the UK to Europe) face an uncertain future.
Recommendations
Expect Japanese companies with (1) a significant proportion of UK sales in total sales, (2) a significant proportion of UK production in total production and (3) large exposure to the EU market to struggle. Auto sales forecasts in the EU have already been lowered.
Beware that the global uncertainty may extend Japan’s investment slump. Factor in a stronger JPY:USD exchange rate in 2016-17.