Japanese manufacturers’ confidence reached its highest level in over three years in September after a tariff agreement with Washington in July. The Reuters Tankan survey showed the manufacturers’ index rose to +13 from +9 in August, marking a third monthly increase. However, expectations suggest a slight decrease to +11 by December. The auto and transport machinery sector saw the most growth, with its index hitting 33 due to stable overseas orders, even with weak domestic output. On the other hand, sectors like textiles, oil refining, and precision machinery voiced concerns about slow orders and lingering tariff effects.

Improvement in the Non-Manufacturing Sector

In September, the non-manufacturing index climbed to +27 from +24 in August. The real estate, retail, and transport sectors all improved. Meanwhile, wholesalers and IT firms faced tough conditions, and the index is expected to remain steady at +27 by December. Japan’s economy has stayed strong amid global trade uncertainty, backed by solid consumption, illustrated by a 2.2% annualized GDP growth in Q2. This stability stems from domestic factors, even as global trade tensions continue to be a challenge. With manufacturer confidence at its highest since August 2022, it is a good time to consider buying near-term call options on the Nikkei 225. The index has risen over 4% in the past month, currently trading near 42,500. This positive momentum, fueled by strong sentiment, presents a clear opportunity for bullish positions in the upcoming weeks. The auto sector shows remarkable strength, suggesting that we should focus on this area. Long positions through futures or call options on major automakers appear attractive, especially as companies have increased profit forecasts following the US trade deal. Historically, when the auto sector leads a Tankan improvement, as it did in late 2023, it tends to outperform the wider market in the following quarter.

Investment Strategy Based on Sector Performance

We can create pairs trades based on the clear differences shown in the report. We should buy transport and machinery stocks while simultaneously purchasing put options on weaker sectors like oil refining and precision machinery. This approach shields us from large market swings while allowing us to benefit from the performance gap between strong and weak industries. The steady growth in the non-manufacturing index, especially in retail, suggests robust domestic consumption. This supports the strong 2.2% GDP growth we observed in the second quarter. Derivatives linked to domestic retail ETFs could offer a stable, secondary long position to complement the export-driven auto trade. However, we must keep a close eye on the yen, which has been trading closely around 152 to the dollar. With core inflation remaining above 2% for over a year, any aggressive signals from the Bank of Japan could strengthen the yen, posing challenges for our exporter positions. Purchasing some out-of-the-money puts on USD/JPY could provide a cost-effective hedge against this risk. The prediction of a slight drop in manufacturer confidence by December suggests that this upward trend may stabilize. This indicates selling volatility for expirations in the next one to two months, but possibly buying volatility further out. We saw a similar trend in 2022, where a strong third quarter led to increased uncertainty and volatility as we approached year-end. Create your live VT Markets account and start trading now.

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