Japan’s stock market is facing these 3 hurdles in August

Japanese equities face three major hurdles in August, including higher oil prices, a more hawkish Federal Reserve and the possible unwinding of crowded equity and foreign-exchange positions, Bank of America strategists said.

BofA said the recent sell-off in artificial intelligence stocks may have completed its initial phase, but warned that further weakness remains possible if those risks intensify.

Higher crude prices could push up inflation and strengthen the case for further Fed rate increases, placing renewed pressure on richly valued technology stocks. BofA economists expect the Fed to raise rates in September, October and December, though the strategists said investors should not completely dismiss an earlier move.

Rising oil prices could also weaken the yen by worsening Japan’s trade balance and supporting the dollar. A rapid move in USD/JPY towards 165 could increase the likelihood of currency intervention, the bank said.

BofA also pointed to growing yen short positions linked to foreign investors hedging their Japanese equity holdings. Combined with heavy positioning in AI stocks, the imbalance resembles conditions ahead of the volatility spike in August 2024.

The bank said August typically brings lower liquidity, and seasonal trends offer little support for momentum and high-beta stocks until mid-month.

If US employment and inflation figures released in early August are subdued, market conditions could begin stabilising from mid-month. BofA expects Japanese stocks to recover towards the end of the year after clearing the near-term hurdles.

The strategists advised investors to retain some AI exposure but avoid companies whose valuations have risen excessively. They said attention could shift from semiconductor businesses driven by expectations of higher prices towards companies benefiting from growth in data-centre investment volumes.

Those areas include optical communications, network infrastructure, semiconductor materials, power equipment, cooling systems and water treatment. BofA also favours diversification into lower-beta domestic businesses in retail, services, food, healthcare, gaming and information technology.