Bernstein: Defensive stocks preferred as Japanese market volatility persists

Investing.com - The recent sell-off in Japan's markets intensified on Friday, with the TOPIX plunging by 6.14%, marking a 13.4% decline from its peak on July 11.

Several factors contributed to this negative sentiment, including the continuing strength of the Yen, which led to the unwinding of the carry trade. Additionally, there are growing concerns about the economic slowdown in the US, increasing market expectations for a more aggressive rate cut environment in the US In the last two weeks of July, foreign investors pulled out $4.7 billion from Japanese equities, and domestic funds also became net sellers in their own market.

Although these factors were expected to impact the markets negatively, the extreme reaction was somewhat surprising.

In the short term, Bernstein anticipates that markets will remain volatile and under pressure, especially given the weak US jobs data, which has heightened fears that the US economic slowdown could be more severe than initially thought.

This slowdown is likely to heavily influence global market sentiment. Historically, Japanese markets have underperformed US equities by 4% to 5% on average during economic slowdowns or recessions.

Japan's market is currently fairly valued against the US 10-year yield levels of 3.7%. However, Japanese value stocks are at significant risk, while quality stocks are likely to benefit if US rate cuts occur, especially if US yields fall below 3.2%.

Therefore, Bernstein recommends rotating towards more defensive, high-quality stocks, or late-cycle value stocks with strong dividend yields.

From a sectoral perspective, there was a noticeable rotation in July, with previously lagging domestic sectors like Software&Services, Retailing, and Food&Beverages showing a comeback. In contrast, traditionally strong sectors like Semiconductors and Autos underperformed.

This aligns with Bernstein’s expectation that sectors benefiting from a strong Yen would perform well. They continue to recommend increasing exposure to these sectors. Historically, domestic sectors such as Retailing, Food&Beverages, Household Products, and Services, as well as export-focused sectors like Healthcare and Media&Entertainment, have performed well in a strong Yen environment, whereas Autos tend to be the most negatively impacted export sector.

Bernstein has maintained a preference for larger companies due to a better earnings outlook compared to small/mid-caps, citing broader economic headwinds. However, a stronger Yen could support domestic industries, where more small/mid-caps are found.

Therefore, in the near term, they emphasize the importance of focusing on defensive and domestic stocks rather than a strict preference for company size.