Japan’s stock market faces a moment of truth

Yen for change. Japan’s stock market rally this year - including the surpassing of a 1989 high - was welcomed as one of the clearest signs that policymakers’ more-than-decade-long push to improve the efficiency of the $4 trillion economy was working. Now the Nikkei 225 and Topix indices are leading a sharp global selloff of equities. The slump will reveal how much substance is beneath the froth in the Asian country.

An overhaul of global interest rates is underway that will reset money managers' risk appetites. The Bank of Japan is hiking borrowing costs while the Federal Reserve is signalling that it may cut them as soon as September; the release on Friday of weak U.S. jobs data is fuelling fears of a hard landing for the economy. Overall, the yen has rallied 7% against the U.S. dollar in five trading sessions; the move is intensified by yen carry trades unwinding where investors borrowed in the Japanese currency to invest in higher-yielding assets.

The appreciation is crushing equities, particularly those helping Japan Inc to generate some 20% of revenue from overseas: the country’s benchmark indices have fallen as much as 15% over the past week, around four times as much as U.S. equivalents including the Nasdaq Composite and S&P 500. Financial stocks ought to benefit from rising Japanese rates but Nomura, Mitsubishi UFJ Financial and Sumitomo Mitsui Financial each plunged about 16% on Monday, erasing about one third or so of their year-to-date gains.

Ultimately the fading stock rally will determine whether the government and Japan Exchange officials have put a floor under the market through reform initiatives. Their efforts to nudge companies to focus on high-return businesses, offload underperforming ones, and shrink the piles of cash are yielding fruit: share buybacks announced by Japanese companies this year have hit 9.3 trillion yen ($65 billion), almost equal to the total in 2023, a record year, per Fidelity.

One big question is where the yen will stabilise. Although its slump became a source of national angst, too rapid an appreciation could mess with the Bank of Japan's plans. The currency’s weakness has kept the price of imported goods high, supporting inflation above the central bank’s 2% target. Governor Kazuo Ueda sent surprisingly hawkish signals last week on the trajectory of Japanese monetary policy despite officials downgrading their GDP growth forecast. The yen could knock far more than just equities off course.

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The Nikkei 225 and the Topix fell by more than 8% and 9% by early afternoon on Aug. 5, adding to losses in the latter half of the previous week that led a broader global equity market sell-off. Trading in the Nikkei 225 was also suspended twice after triggering circuit breakers. The benchmark stock indices have fallen sharply following the Bank of Japan's decision to raise interest rates on July 31. On the same day Japan hiked rates, the U.S. Federal Reserve signalled it may cut rates as soon as September.