The Great Divergence: Why Japanese and Chinese Stocks Are Moving Apart

In regional equity allocation, Japan and China often function as a financial seesaw; when one market attracts international inflows, the other frequently suffers outflows. Having started in the investment business back in 1986, I witnessed Japan enter the top tier of the equity world that year, only for the 1987 crash to change everything. Since then, Japan has been on a long climb back, while China's stock market has grown into one of the largest in the world. For an investor looking to diversify out of pricey U.S. mega-cap stocks, investigating this dynamic is crucial.

The Great Divergence in Asian Markets: EWJ and FXI's Opposing Paths

Recently, the iShares MSCI Japan ETF (EWJ) and major China vehicles like the iShares China Large-Cap ETF (FXI) have decoupled, moving in opposite directions. This is actually reversing the pattern of the past 12 months, where FXI lagged by more than 20% and traded at a steep price-earnings discount to EWJ. Technical analysis reveals a shifting landscape:

■EWJ is showing a recent topping pattern; while it is early, the 20-day moving average has started to roll over and the percentage price oscillator (PPO) is crossing into negative momentum territory.

■In contrast, FXI looks much better than most in this weak global stock market environment.

These major markets are clearly moving in separate directions, requiring a nuanced understanding of the underlying drivers.

Central Bank Policy Shifts and Currency Mechanics

Understanding why this divergence occurs requires examining policy differences and currency mechanics. The Bank of Japan (BOJ) is moving away from decades of ultra-loose monetary policy, raising interest rates and unwinding yield curve control. Higher domestic rates bolster the Japanese yen, but they also compress valuation multiples for export-heavy Japanese equities and create friction for global yen carry trades.

Japan's monetary policy normalization and the valuation discounts in China signal a pivotal shift for the tech supply chain. A stronger yen directly impacts the cost structure of Asia-based semiconductor giants like TSMC and ASML, altering arbitrage opportunities towards US stocks like Nvidia. Signs of stabilization in Chinese equities could reprice the risk premium on rare earth element supplies, a critical factor for chip manufacturing.