Foreign ownership reaches a historic high of 34.7%, yen’s continued decline may reverse capital flows in Japanese stocks

According to Zhihui Finance APP, the yen has been declining continuously in recent times, causing widespread concern among investors. If the depreciation trend does not reverse, it could eventually undermine the key driver that has pushed Japan’s stock market to repeated historic highs—foreign capital inflows.

On the surface, data from overseas-listed exchange traded funds (ETFs) still reflect strong international investor demand for Japanese equities. Compiled data show that in recent years, unhedged ETFs investing in the Japanese market have seen sustained attractiveness, with cumulative net inflows reaching $47 billion; in contrast, their currency-hedged counterparts have witnessed capital outflows.

However, strategists warn that this situation could change rapidly. Pension funds and long-only asset managers typically do not hedge currency risk, making their investment returns increasingly vulnerable as the yen continues to weaken. The market is beginning to question: how much further must the yen fall before currency losses outweigh the inherent appeal of Japanese equities?

Richard Kaye, co-head of Japanese equity strategy at Comgest Asset Management France, stated: “Currency risk is one of the core concerns facing Japanese stocks right now.” Despite Japan remaining a key destination for global investors seeking AI-themed opportunities outside the US, the persistent depreciation of the yen has become increasingly hard to ignore for those with little to no currency hedging.

Year-to-date, the TOPIX index has surged 19%, setting a new record. However, in dollar terms, the gain narrows to about 14%, as the yen-dollar exchange rate has slipped below the 163 level—its lowest since 1986. The main factors weighing on the yen are the widening interest rate differential and market concerns over Japan's fiscal outlook.

The growing influence of foreign investors has made exchange-rate effects even harder to ignore. Exchange data show that by the end of March, foreign funds held 34.7% of Japan’s stock market capitalization—a record high, up from 30.2% five years ago. Since Sanae Takaichi won the Liberal Democratic Party leadership election and became prime minister last October, foreign funds have recorded cumulative net purchases exceeding 12 trillion yen (about $74 billion) in Japanese cash equities.

This wave of foreign capital is also markedly different from the past. Yoshitaka Suda, senior cross-asset strategist at Nomura Singapore, pointed out that in the early days of former Prime Minister Shinzo Abe’s administration, foreign inflows mainly came from short-term funds that typically hedged currency risk. The leading force in this rally, however, is long-term investors like pension funds, who often do not hedge currency risk. “From a flow perspective, the positive impact of yen depreciation on Japanese equities is no longer as clear as it was before.”

Of course, yen depreciation still supports earnings for exporters. Professional estimates indicate that if the yen remains at current lows, Japan’s major automakers could collectively generate over 900 billion yen in additional profit.

However, Kazunori Tatebe, chief strategist at Daiwa Asset Management, remarked: “With the yen hitting historic lows and no sign of halting its depreciation, many believe investors without currency hedging may pause buying until exchange rates stabilize.”

Overall, the impact of yen depreciation on Japanese equities has shifted from a “clear positive” to a “double-edged sword”—while boosting export profits, it is gradually eroding the real returns for unhedged foreign funds and could ultimately shake the foundation of the current bull market.