Investors will closely watch the Japanese general election on October 27. The Bank of Japan (BoJ) is not expected to hike rates in the upcoming meeting.

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Over the past five years, the Russell 2000 has lagged behind the other major U.S. equity indices, with small-cap stocks significantly underperforming compared to the tech-driven market leaders.

The Russell 2000 has rallied to a key resistance level near 2300. With both the S&P 500 and Dow Jones surpassing their July highs, the Russell 2000 may be poised to follow suit.

The Nikkei 225 Index and USD/JPY maintain a strong correlation due to the impact of the yen's strength on major companies in the index. As U.S.-Japan interest rate differentials narrow, further yen appreciation is expected, adding downside pressure to the Nikkei 225 as a stronger yen leads to less competitiveness for Japanese exporters.

The Nikkei 225 Index appears to have formed a Diamond Top pattern, a formation typically seen at the end of an uptrend, signaling a potential bearish reversal.

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While the 2024 U.S. presidential election is approaching, now less than three weeks away, our distant vantage point allows us to assess the situation more objectively. Without direct political or ideological involvement, we can evaluate the probabilities of this crucial event—one that has significant implications for global markets—with a level of detachment. This perspective enables us to capitalize on opportunities and manage risks effectively.

Recent polls from various sources suggest that former President Donald Trump currently holds a 57% chance of winning, compared to 48% for current Vice President Kamala Harris. This marks the widest margin since late July. A key question now arises: Is the market prepared for a potential second Trump administration?

U.S. equity markets seem only partially priced in for such an outcome. Following the near-assassination of Trump on July 13, which was a historic event, his election odds surged above 66%. This spike triggered a notable rotation from tech stocks to small-cap stocks, a shift we discussed in our early July report. The Trump-Vance ticket is perceived as pro-small business and focused on supporting the "real economy." This sentiment was reflected in the stark divergence between the Russell 2000 and the Nasdaq, with the gap widening to 18% by July 31. The Russell 2000 gained over 9% during that period, while the Nasdaq dropped by a similar margin. However, as the event receded from the public's attention, Trump's election odds fell back below 50%, and Russell's performance relative to the Nasdaq diminished. Today, while we see early signs of renewed strength in the Russell, the divergence to the Nasdaq is nowhere near the magnitude we've seen in July.

Across the Pacific, Japan is also heading into a significant political event, with a general election set for October 27. The new Prime Minister, Shigeru Ishiba, called the election shortly after his appointment as the leader of the ruling Liberal Democratic Party (LDP) in late September. Despite the LDP's dominance over the past seven decades, the party now faces increasing criticism due to recent corruption scandals and rising dissatisfaction amid the ongoing cost-of-living crisis. A recent Nikkei poll indicates that the LDP may fail to secure a majority, a scenario the newspaper warns could lead to political instability not seen since 2009.

This political uncertainty is weighing on the short-term outlook for the Japanese equity market, especially as the Bank of Japan (BoJ) has recently begun the process of normalizing monetary policy. Prime Minister Ishiba is largely viewed as neutral regarding BoJ policy decisions. However, given the challenges facing the LDP, the potential influence of Sanae Takaichi, a prominent LDP figure known for her ultra-dovish stance and support for Abenomics' ultra-easy monetary policies, cannot be discounted. This has led us to believe that the BoJ is unlikely to raise rates at its upcoming meeting at the end of October or even in December.

Japan's near-term risks are compounded by the potential impact of a second Trump presidency, which could introduce more tariffs and protectionist measures targeting key industries like automotive manufacturing—a sector critical to Japan's economy. While Japan has existing trade agreements with the U.S., many of its major industries remain vulnerable. Additionally, a popular trade among global asset allocators in recent months has been long Japan and short China. However, if China's central bank and government continue their stimulus measures beyond the current speculation phase, we could see a significant rotation of capital out of Japan and into China, further exacerbating the downside risk for Japanese equities in the months ahead.

Given these uncertainties, our portfolio preference would be to tactically employ long/short positions in equities. This strategy helps to manage overall market exposure while capitalizing on opportunities from relative value plays and market dislocations.

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We consider expressing our views via the following hypothetical trades¹:

Case study 1: Long E-mini Russell 2000 Index Futures

Given the early signs of renewed strength in the Russell, we would consider taking a long position in the E-mini Russell 2000 Index Futures (RTYZ4) at the current price of 2296, with a stop-loss below 2180, a hypothetical maximum loss of 2296 – 2180 = 116 points. If the overhead resistance is broken, Russell 2000 has the potential to rise to 2466, the previous high registered in late 2021, resulting in a potential profit of 2466 – 2296 = 170 points. Each point move in the E-mini Russell 2000 Index Futures contract is 50 USD. Micro E-mini Russell 2000 Index Futures (M2K) are available at 1/10th of the standard size.

Case study 2: Short Nikkei 225 (USD) Index Futures

We would consider taking a short position in the Nikkei 225 (USD) Index Futures (NKDZ4) at the current price of 39270, with a stop-loss above 41000, a hypothetical maximum loss of 41000 – 39270 = 1730 points. Looking at Figure 4, if the Diamond Top pattern is confirmed, the Nikkei 225 index has the potential to fall back to 33000, resulting in a potential profit of 39270 – 33000 = 6270 points. Each point move in the Nikkei 225 (USD) Index Futures contract if 5 USD. Effective October 28, CME Group will launch Micro Nikkei (USD) Futures and Micro Nikkei (JPY) Futures at 1/10th of the standard size, which allows more flexibility and greater precision for traders to express their market views on Japanese equity market. Please visit this page for more information about the Micro Nikkei Futures.

¹ Examples cited above are for illustration only and shall not be construed as investment recommendations or advice. They serve as an integral part of a case study to demonstrate fundamental concepts in risk management under given market scenarios. Please refer to full disclaimers at the end of the commentary.

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