Why the Nikkei 225’s Sharp Drop Is About More Than Just the Middle East

The data from Tokyo’s trading floor early on Monday morning revealed a narrative that anyone following the world’s markets for the previous five weeks was already familiar with. The Nikkei 225 began the day at 52,054, fell precipitously during the session, and ended at 51,885, down almost 3 percent for the day and nearly 4 percent at the intraday low of 50,566. The extent of the sell-off was clear: only 374 stocks rose on the Tokyo Stock Exchange, while 3,341 stocks fell. This ratio does not imply sector rotation or selective profit-taking. It implies something more akin to generalized risk reduction, which occurs when investors in different time zones decide at the same time that they would prefer to temporarily hold less of everything.

The most obvious factor is the Iran conflict, which is currently in its fifth week. The same geopolitical pressure that propelled the Houthi missile attacks on Israel over the weekend—the first direct Houthi involvement in the US-Israel-Iran conflict, according to reports—also caused Brent crude to close at about $108.97 per barrel, indicating that the regional containment that everyone had been secretly hoping for isn’t happening. Spikes in oil prices have a particular economic impact on Japan that does not apply to countries that produce oil. Nearly all of Japan’s oil is imported. The cost of operating Japanese manufacturing, transportation, and power generation increases when Brent moves closer to $110, which eventually affects consumer prices by directly affecting corporate margins. On Monday, the yen was trading at 159.85 to the dollar. This weak yen environment raises the cost of oil imports because Japan pays for crude in dollars and receives far fewer dollars per yen when the currency is under pressure.

The import-exposure narrative was directly revealed by the stocks that drove the declines. Mitsubishi Motors hit three-year lows, closing at 308 yen after falling 7.89 percent. Mazda saw a 7.30 percent decline. Taiyo Yuden, a manufacturer of electronic components whose supply chains pass through international shipping lanes that are currently marked by conflict risk, saw a 7.27 percent decline. SoftBank Group saw a 6.44 percent decline. The manufacturer of heavy machinery, Komatsu, suffered a similar fate. A particular company-level event isn’t punishing these defensive stocks. As investors attempt to determine how a prolonged period of high oil prices and geopolitical uncertainty affects their earnings assumptions, these cyclical, export-oriented, or energy-cost-sensitive businesses are being repriced collectively.

A level of complexity that was absent from previous market downturns has been introduced by the Bank of Japan’s counterpressure. According to a summary of opinions published on Monday, policymakers discussed the necessity of additional rate hikes during the BOJ’s March meeting. One member specifically pointed out the danger of falling behind the curve, pointing out that the Middle East conflict-related rise in oil prices is creating inflationary pressure that might compel the central bank to tighten more quickly than its current schedule suggests. The yield on Japan’s 10-year government bonds reached a 27-year high on Monday, indicating that the bond market is pricing in that exact scenario. This presents an unsettling paradox for equity investors: the same factors driving up inflation are also driving down corporate profits, and the policy response to inflation may tighten financial conditions at the wrong time.

The Nikkei’s 52-week range provides a more comprehensive narrative that is worth considering. 59,332 was the peak. 51,885 is the current level. 30,792 was the low, which was reached earlier in the previous year. The recovery from those lows to the highs was, for a while, one of the more compelling equity stories worldwide. This was fueled by corporate governance reforms, improving return on equity across Japanese companies, and the Bank of Japan’s gradual normalization of monetary policy after decades of negative rates. The index has already shown that it can move through enormous ranges when global conditions shift. There are still a lot of those structural advancements. The story of governance hasn’t changed. Despite the current pressure from oil prices, the quality of corporate earnings hasn’t fundamentally declined. In fact, JGC Holdings increased 2.35 percent on Monday, serving as a minor reminder that energy-services firms profit when oil companies increase their expenditures. Even in a widespread sell-off, not everything moves in the same direction.

It’s difficult to ignore the fact that Japan’s current market conditions are a condensed version of a problem that every major economy faces at the same time: how to control the growth and inflation effects of an unresolved conflict in a setting where monetary policy is already stretched in conflicting directions. Using the same reasoning, the South Korean Kospi dropped 5% before rising to close down at about 3%. Australian stocks fell 0.65 percent. Hang Seng in Hong Kong dropped more than 1%. Because of the yen’s sensitivity to oil prices and the concentration of export-oriented, energy-intensive industry in its component stocks, the Nikkei experienced the biggest absolute decline. The next week’s diplomatic signal from the Iran conflict that markets can take as a sign of a resolution will largely determine whether Monday’s session represents a turning point or an accelerating decline. As of yet, no such signal is visible.