Japanese manufacturers’ confidence reached its highest point in over three years in September, following a tariff agreement with Washington in July. According to the Reuters Tankan survey, the manufacturers’ index increased to +13 from +9 in August, achieving a third consecutive monthly rise. However, expectations indicate a slight decrease to +11 by December.
The auto and transport machinery sector experienced the most improvement, with its index reaching 33, due to stable overseas orders, despite weak domestic output. Conversely, sectors such as textiles, oil refining, and precision machinery expressed concerns over sluggish orders and ongoing tariff impacts.
Improvement in the Non-Manufacturing Sector
In September, the non-manufacturing index rose to +27 from +24 in August, with real estate, retail, and transport sectors seeing improvement. However, wholesalers and IT companies reported challenging conditions, with the index anticipated to remain steady at +27 by December.
Japan’s economy has been resilient amidst global trade uncertainties, supported by robust consumption, as evidenced by a 2.2% annualised GDP growth in Q2. This stability is driven by domestic factors even as global trade tensions continue to pose challenges.
With manufacturer confidence at its highest since August 2022, we should consider buying near-term call options on the Nikkei 225. The index has already responded positively, gaining over 4% in the last month to trade near 42,500. This momentum, backed by strong sentiment, presents a clear opportunity for bullish positioning in the coming weeks.
The auto sector is showing exceptional strength, so we should overweight this area. Long positions through futures or call options on major automakers are attractive, especially as companies have revised profit forecasts upwards following the US trade deal. Historically, when the auto sector has led a Tankan improvement, as it did in late 2023, it has often out-performed the broader market for the subsequent quarter.
Investment Strategy Based on Sector Performance
We can also structure pairs trades based on the clear divergence in the report. We should go long on transport and machinery stocks while simultaneously buying put options on weaker sectors like oil refining and precision machinery. This strategy insulates us from broad market moves while capturing the performance gap between the leading and lagging industries.
The steady strength in the non-manufacturing index, particularly in retail, suggests solid domestic consumption. This confirms the strong 2.2% GDP growth we saw in the second quarter. Derivatives tied to domestic retail ETFs could provide a stable, secondary long position to complement the more export-driven auto trade.
However, we must watch the yen closely, as it has been trading in a tight range around 152 to the dollar. With core inflation holding above 2% for over a year now, any hawkish signal from the Bank of Japan could cause the yen to strengthen, creating headwinds for our exporter positions. Buying some out-of-the-money puts on USD/JPY could be a cheap hedge against this risk.
The outlook for a slight dip in manufacturer confidence by December suggests this upward trend may level off. This points towards selling volatility for expirations in the next one to two months, but possibly buying volatility further out. We saw a similar pattern in 2022, where a strong third quarter gave way to increased uncertainty and choppiness heading into year-end.
