Investment Update: Why should Japanese investors own gold?

While major Japanese and global assets have witnessed declines in H1, gold has delivered a 19% return in local currency over the same period ¹.  Gold’s performance was driven by  a combination of rising inflation, geopolitical risks and a weaker yen (Chart 1). 

In sharp contrast to other major central banks, the Bank of Japan (BoJ) has maintained its loose monetary policy to support economic recovery. Limited local bond yield movements may weaken the role of Japanese government bonds (JGB) as a risk hedge, while the gloomy global and domestic economic outlook could present additional challenges to Japanese investors. And, as the risk of global stagflation rises, gold’s role as a strategic asset may become more relevant for local portfolios. 

Our analysis, based on historical data and hypothetical portfolio compositions, shows that a 5% allocation to gold can help Japanese pension funds improve their returns and reduce risk. Historical analysis also suggests that gold is an effective tool to preserve purchasing power. 

H1 2022: yen weakness, financial market turmoil and gold strength

The Japanese yen (JPY) has weakened markedly in recent months, depreciating by 18% against the dollar so far in 2022.² A key driver lies in the divergence between monetary policy in Japan and other markets, such as the US. While the US Federal Reserve (Fed) is aggressively hiking rates to battle intensifying inflationary pressures, the BoJ is continuing its qualitative and quantitative easing (QQE) and yield curve control (YCC) programs.³ 

As a result, the US-Japan interest rate spread has widened, weighing on the Japanese currency. Alongside this, a deteriorating trade account balance amid higher importing costs has contributed to a weaker yen.⁴  

Financial markets have also been unsettled. Negative Japanese real economic growth in Q1 – mainly driven by the spread of the Omicron variant and higher import costs⁵ – combined with yen weakness and global geopolitical risks have pressured local equities this year. At the same time, global bond markets, an important component of Japanese investor portfolios, have been volatile amid higher interest rates and escalating inflation in key regions. 

But gold in yen has done well, driven by demand for hedges and partially buoyed by a weak JPY (Chart 2). Even though higher global interest rates have posed challenges, inflationary concerns and geopolitical risks have supported gold ⁶.  While a stronger dollar limited gold’s upside, gold in yen terms rose by 19% during the first half  of 2022, fully making up for yen’s depreciation against the dollar. 
 

Challenges facing Japanese investors 

Japanese institutional investors may have felt the pinch from both local and international markets

With the low-yield environment persisting for years, Japanese institutional investors often allocate a significant portion of their assets to international markets in search for growth (Chart 3). For instance, the Japanese Government Pension Investment Fund (GPIF)’s exposure to foreign assets reached 50% in Q3 2021. And the average corporate pension fund has a 30% allocation to foreign investment. Furthermore, the 2022 Global Pension Assets Study pointed out that domestic equities and bonds have had a consistently declining share of the total equity and bond exposure of Japan’s pension assets. 

Bonds, locally and globally, might become less attractive 

Bond yields in Japan may remain capped. As KURODA Haruhiko, the Governor of the BoJ, emphasised during the BoJ’s last meeting, the central bank has vowed to keep monetary policy loose to support the country’s economic recovery. And the BoJ has recently shown its resolution to keep local bond yields down despite higher inflation expectations and traders’ positioning on the possibility of a marginal pivot in the BoJ’s policy stance in the future. On 15 June the central bank raised its five-to-10-year JGB purchase offer to 800bn yen from 500bn after the 10-year JGB yield rose above the 0.25% upper tolerance band set by the BoJ. It also announced a surprising offer to buy long-dated bonds on the same day as the 30-year JGB yield surged.⁷ 

In the third phase of QQE, which was first introduced in September 2016, the YCC program has helped the BoJ keep rates low and accommodate Japanese economic growth. But there are potential side effects, especially for local investors. For one, limited yield moves amid the central bank’s control may have been a key contributor to JGBs’ diminishing effectiveness in diversifying local equity market risks since 2016 (Chart 4). 

Also, the BoJ’s recent statement indicates that the low-yield environment in Japan may last for a while yet. And we believe the prioritisation of accommodating local economic recovery and achieving demand-pulled core inflation target of 2% in a sustainable manner means the BoJ’s dovish monetary policy stance may last for longer. And this will likely drive local investors to search for returns via riskier assets or international markets. 

But international bond markets are no heaven for Japanese investors either. While US treasuries could offer higher yields, they have been volatile so far this year. Amid the Fed’s aggressive rate hikes the Bloomberg US Treasury Aggregate Index has lost 14% in H1 2022 and its six-month rolling volatility shot up to the highest since 2008. 

After accounting for surging currency hedging costs, pushed up by the stark interest rate gap between Japan and the US, rising US treasury yields may not seem so attractive (Chart 5). 

Growth challenges are mounting domestically and globally 

In recent months, fears of a worldwide stagflation risk have mounted. According to the World Bank, the prolonged Russia-Ukraine war has brought significant supply chain shocks, pushing up commodity prices globally. And they may remain elevated for years. The World Bank has also revised its global growth forecast sharply downwards due to uncertainties and geopolitical risks, such as the potential slowdown in China’s economic growth. 

According to our previous analysis and definition, lower growth – reflected by changes in the US Conference Board Index – coupled with higher inflation, could indicate that stagflation has already arrived (Chart 6).

And Japan faces its own issues. Raw material prices remain stubbornly high and corporates’ profits are being squeezed. Even though their costs are higher, decades-long stagnant wage growth in Japan and the kinked demand curve – a situation where a small price rise leads to a significant reduction in demand – are making local wholesalers cautious about passing on price increases to their customers. ⁸ This is partially reflected in the widening gap between Japan’s wholesale and retail costs (Chart 7). 

But the gap will narrow eventually, one way or another. Taking current commodity market dynamics into consideration, rises in retail prices is more likely – even though they will mean heavier burdens for households and a potential reduction in demand. 

And Japan’s trade deficit poses additional challenges. As a nation that depends on external natural resources such as crude oil,⁹ Japan’s import costs have risen markedly amid higher commodity prices. This has happened as global growth has showed signs of a slowdown and at a time when China, accounting for a third of Japan’s exports in 2021¹⁰, may also see economic deceleration.  Elevated import costs and potentially weaker external demand could mean an outflow of income will continue to bite.

Squeezed profits in upstream sectors, cost pressures on vulnerable retail demand and the inevitable outflow of income, combined with factors we mentioned previously, may be key reasons why the BoJ sets itself apart from the tightening policy of other central banks. 
Global growth slowdown and local economic pressure may finally translate into higher financial market volatilities. And, we believe, gold could become an effective tool to enhance the performance of local investor portfolios. 

Gold’s value to Japanese investors

Gold’s recent performance has highlighted its strategic value for Japanese investors amid global uncertainties and yen weakness. And as stagflation risks rise, gold may become even more attractive to investors for its superior performance when measured against other major assets in a stagflation environment (Chart 8). 

Why should Japanese investors consider buying gold?

Gold’s role as a strategic asset is best illustrated with an example. Turning to the aforementioned GPIF, our analysis shows that, over the past 20 years, the risk-return profile of a hypothetical GPIF portfolio is improved with a 5% allocation of gold whilst proportionally reducing the weight of other assets (Table 1): 
 

Similar enhancement can also be observed when adding 5% gold to an average Japanese corporate pension fund portfolio, as mentioned previously: gold helps lift return and reduce risk (Table 2). 

Table 2: Gold also improves an average hypothetical Japanese corporate pension portfolio’s performance* 

Such improvement mainly stems from gold’s ability to provide a long-term return and its negative correlation with Japanese and global equities when they are in distress. Our analysis also shows that gold, in yen, has delivered an annualised return of 6% since 1971, 9% over the past 20 years and 10% over the past five years. And gold enjoys a highly liquid market, which usually translates into lower trading costs and a narrower bid-ask spread – in June 2022 gold’s trading volume averaged 16tn yen per day. 

Additionally, gold’s recent performance in yen has underpinned its role as a means to protect purchasing power. Historical data tells us that due to its limited supply and stable demand, gold has never lost value against fiat currencies (Chart 9).

Conclusion

Gold has delivered outstanding returns for Japanese investors so far in 2022, outperforming many other JPY assets. Rising inflationary concerns worldwide, intensifying geopolitical risks, and a weaker yen have been the main contributors to JPY gold’s strength. 

Looking ahead, with the BoJ’s QQE and YCC programs remaining in place, the role of local bonds as an equity market diversifier may become less effective. And we believe the BoJ is likely to maintain a dovish policy stance as growth risk remains and keep its local yields low for longer. 

And bonds from other markets may be expensive for Japanese investors due to higher currency hedging costs. To make things worse, global and domestic financial markets may remain turbulent amid cloudy growth outlooks. 

These risks will not only make investors wary but will likely increase gold’s relevance as a strategic asset for Japanese investors. Our performance tests of hypothetical Japanese pension portfolios, based on historical data, have revealed gold’s ability to enhance returns and reduce risks. Moreover, gold can also offer purchasing power protection for local households.