 Japan factor dispersion, investor’s positioning and volatility outlook: Amid  fears of hastened interest rate hikes in the US, the VNKY index reached a local  peak of 30 towards end January 2022 and has been on a normalization path  since then. A closer look at the sources of volatility reveals that a rise in average  single stock volatility, especially those with high valuations, significantly  outweighs the volatility dampening impact coming from declines in factor  correlation. The pace of a further rise in bond yields is key to determine the  volatility reaction function going forward. Historically, Japanese equities tend  to perform well for an up-to-2.5x standard deviation rise in US 10-year real  rates. Any signs of a slower rise in real rates from here could be followed by a  rebound in share prices, which could lead to a decline in volatility.

 The rotation into value stocks that occurred at the start of this year is still at its  early stage, in our view. Year-to-date outperformance in Japan value vs growth  stocks is mainly due to selloff in overvalued growth names rather than absolute  gains in value names. Past episodes suggest further normalization in volatility  will come as market leadership transitions to one that is driven by value.