It's not AI, nor is it war; what the US stock market should be most concerned about is Japan?

Author: Zhao Ying

Global markets are underestimating a potential systemic risk—Japan. As the yen falls to decades-low levels and the attractiveness of domestic assets rises, the world's largest pension fund is facing policy pressure to repatriate assets on a large scale. Once this process begins, the U.S. stock market, bond market, and the dollar may come under simultaneous pressure.

Recently, Japanese Prime Minister Sanae Takaichi stated that the government will promote the Government Pension Investment Fund (GPIF) and other national pension funds to increase investments in domestic financial assets. Finance Minister Shunichi Suzuki also sent similar signals earlier. Although GPIF has not announced any formal asset allocation adjustments, the market has begun to assess its potential impact: if the fund shifts overseas holdings back to domestic assets, U.S. Treasury yields may rise, the dollar may weaken, and risk assets may come under pressure.

Currently, the market's pricing of the aforementioned risks remains relatively calm, but some technical indicators have shown subtle changes, and investors should not be complacent.

$1.8 trillion variable

GPIF manages approximately $1.8 trillion, with domestic and foreign assets each accounting for about half, of which overseas holdings total about $930 billion. In recent years, the scale of Japanese government bonds held by the fund has decreased from about $770 billion to about $515 billion, while foreign bond holdings have increased from about $128 billion to about $470 billion.

This structural change means that even a slight reallocation of assets could trigger significant volatility in global markets. According to MarketWatch, analyst Michael Kramer pointed out that if GPIF shifts some overseas assets back to domestic investments, it will directly boost demand for the yen and introduce large-scale buying into the Japanese government bond market—beneficial for Japan, but implying higher rates and a weaker dollar for the U.S.

At the same time, if large-scale unwinding of yen carry trades (borrowing low-interest yen to invest in U.S. assets) occurs, it will further suppress the performance of risk assets.

Yen and Japanese Bonds: The Attractiveness of Domestic Assets is Rising

Behind the potential reallocation by GPIF is a substantial improvement in the fundamentals of domestic assets. As inflation in Japan rises and economic growth recovers, the attractiveness of local investment opportunities has significantly increased. In February of this year, the yield spread between Japanese and U.S. two-year government bonds narrowed to its lowest level since early 2022.

At the same time, the yen continues to weaken, with the dollar-yen exchange rate breaking 163, the highest level since 1986. From a technical analysis perspective, if the exchange rate rises further, the next resistance level is around 176. According to the Financial Times, Fredrik Repton of Neuberger Berman believes that if GPIF allocates more funds to domestic assets, it could be a "very elegant solution" to Japan's macro issues, but other domestic financial institutions also need to follow suit, and "this process will take a long time."

Recently, the yield on Japan's 10-year government bonds reached 2.7%, the highest in 30 years. Deutsche Bank analyst Mallika Sachdeva pointed out in a recent report that the focus of Japanese authorities' policies may be shifting from exchange rate management to yield management, and if this shift occurs, it will further pressure the yen.

The market has not priced this in yet, but signals are emerging

Currently, the global market's response to the risk of capital repatriation from Japan remains relatively restrained. The five-year dollar-yen cross-currency basis swap is recently around negative 30 basis points, the narrowest level since this series of data was introduced in 2021, indicating that the market's demand for hedging against yen appreciation has not significantly increased.

However, this indicator itself is a key signal for observing whether the flow of funds is beginning to change. Historical data shows that the S&P 500 index and the cross-currency basis swap have exhibited synchronous movements during multiple periods—whenever hedging demand rises sharply, the U.S. stock market often declines as liquidity tightens. Once market expectations for yen appreciation heat up, demand for dollar hedging will rise, and the liquidity tightening effect will become more pronounced.

Japanese Stock Market: Another Side of Risk

It is worth noting that GPIF's potential asset reallocation, while bringing pressure to the U.S. market, also provides a new narrative logic for the Japanese stock market. The Japanese stock market is benefiting from drivers that are distinctly different from those of the U.S. market: the concentration of the technology sector in the Topix index is much lower than that of the S&P 500, exposure to artificial intelligence is relatively limited, and valuations are still over 20% discounted compared to the S&P 500.

Corporate governance reform is a core catalyst for the Japanese stock market. Dan Rasmussen of Verdad Advisers points out that there are still about 1,000 companies in Japan whose stock prices are below book value, and among the cheapest fifth of companies, cross-shareholdings still account for about 40% of their market value. As cross-shareholdings are gradually unwound, a large amount of historically accumulated profits is expected to be released, which will have a substantial positive impact on corporate earnings.

However, for overseas investors, the continuously weakening yen is the biggest obstacle—over the past two years, the depreciation of the yen has significantly eroded the actual returns of foreign capital in the Japanese stock market. How to handle currency hedging and whether the hedging costs are bearable remain core issues facing global investors.