This is the real reason Japanese stocks are rallying

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Japanese stocks have been on a tear in October, closing higher in each of the past 15 sessions, the longest winning streak on record.

On Monday, the Nikkei 225 added 1.11%, closing the session at 21,696.65 points, leaving it at the highest level since July 1996.

Just look at the daily chart below.

Nikkei 225 Daily Chart

Bullish, right?

While some put Monday’s rally down to the outcome of the Japanese election held on Sunday, returning Shinzo Abe as Prime Minister in a landslide result, Masao Muraki, Hiroshi Torii and Tao Xu, research analysts at Deutsche Bank, don’t believe Abe’s re-election had much to do with the rally, suggesting that there are other factors that explain why Japanese stocks have been on a tear over the past few weeks.

“In our view, the main reasons for the 7% rise in Japanese stocks since September were a rise in US long-term rates, higher commodity prices, expectations of firm US earnings, especially in industrials and IT sectors, and yen depreciation,” they say.

“More than half could be attributed to a rise in US rates. It is hard to imagine that Japan’s Lower House elections had a large impact on these four factors.”

So while politics may have fit the narrative behind Monday’s rally, the reality to Muraki, Torii and Xu is that it was more likely driven by the same factors that helped to propel the index higher over the proceeding 14 sessions.

From a broader perspective, the trio say the current combination of strong economic conditions, low interest rates, low inflation, and narrow credit spreads are supporting a rise in value of risk assets.

As for what may break this trend, Deutsche says that a further increase in US bond yields, leading potentially to a stronger US dollar, appear the most likely threats looking forward.

“We would watch out for the risk where a sustained rate rise results in overheating,” Muraki, Torii and Xu say.

“Further rise in rate could weigh on commodity prices, and dollar appreciation could have an adverse impact on the emerging markets. It could also negatively impact sectors with high valuations such as IT sector.”

If that doesn’t eventuate, they say that risk asset prices — including stocks — will likely keep rising.

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