The AI boom is boosting Japanese stocks; will this trend continue?

A few tech winners have boosted Japanese stocks, but foreign investors have found the weakening yen to be a hindrance, according to Kaylie Pferten

Japanese stock investors, like investors worldwide, should be wary of concentrated exposure to the AI narrative. It has changed over the last few months from being significant to essential.

No matter where you look, the best-performing stocks are associated with AI demand, while the "AI loser" or AI-agnostic stocks are typically lagging. Because of TSMC, Samsung Electronics, and SK Hynix, the emerging markets index is currently trading like an AI play, though this is by no means the only instance.

Companies like Kioxia, a chipmaker that shot up from 1,455 when it floated in December 2024 to a high of 112,700 in June, are among the best-performing Japanese stocks. Softbank, a tech conglomerate, and companies that manufacture and test chips, like Advantest, Murata Manufacturing, and Tokyo Electron, are other major players.

Unbelievable-sounding businesses like the toilet manufacturer Toto and the food seasonings company Ajinomoto have also been carried along because their primary businesses make them leaders in materials that are involved in the supply chain for chips.

The year has started off well for Japanese stocks.

According to Alex Bowles and Brett Moshal of asset manager Orbis' Japan equity team, "the result has been an unusually narrow, yet powerful market." Only one-third of Japanese stocks have outperformed the benchmark as of the end of June, despite the Topix index's impressive start to the year (up 19%). Fourteen percentage points of that return can be attributed to a basket of sixty-seven AI companies.

Although Bowles and Moshal contend that it is also generating contrarian opportunities, this has been a challenge for investors who are not familiar with AI. They cite both the threat that AI poses to Nintendo's competitive edge in game development and the company's halving due to concerns that a memory shortage would negatively impact hardware sales in the near future. They contend that this is excessive given the strength of Nintendo's intellectual property.

The weakening yen discouraged foreign investors.

If the AI boom ends badly, diversification across regions might not be much protection. However, for the time being, the market is still doing well, and the currency is a barrier for foreigners.

At 163 to the US dollar and 218 to the pound, the yen continues to decline. Despite the finance minister's discussion of "appropriate and bold action" this week, there hasn't been much evidence of this bottoming out. According to Jim Reid and his colleagues at Deutsche Bank, this has made living in Japan one of the most affordable developed-market nations. In terms of purchasing power parity, Japan is currently ranked at 60, compared to 125 in 2012, when price levels are calculated using the US as 100.

Theoretically, the yen is significantly undervalued. However, this has been almost universally accepted, and it continues to decline. Our exchange-traded fund (ETF) portfolio has performed well in Japan thanks to Vanguard FTSE Japan (LSE: VJPN); however, it is obvious that a currency-hedged ETF would have performed better. Since we anticipate a yen rally, we are sticking with the unhedged position. However, there are other options to reduce the risk if it declines further, such as iShares MSCI Japan GBP Hedged (LSE: IJPH) or UBS Core MSCI Japan hGBP (LSE: UB0D).

MSCI in Japan.