Some investors are starting to position for a scenario Japan hasn¡¯t faced in decades, as rising oil prices and a weaker currency stoke stagflation worries and force a rethink of bets.

Global funds including Allianz Global Investors and Amundi are already hedging against stagflation ¡ª a mix of rising prices and slowing growth ¡ª with the Iran conflict nearing the one-month mark. Allianz has reinforced its underweight view on Japanese government bonds (JGBs) and turned neutral on equities and the yen while using options to hedge volatility. Amundi has trimmed its overweight stance for Japanese stocks and is neutral on the nation¡¯s currency, with intervention risks in mind.

While stagflation isn¡¯t the central scenario for most investors in Japan, the risk carries a lot of weight for an economy that only recently emerged from decades of deflation. A slide into stagflation would challenge the country¡¯s recovery narrative and broader investment case. Wages are rising, but investors warn that a prolonged period of elevated oil prices could erode those gains before they translate into stronger spending.

Japan is feeling the pain of the war acutely as it imports more than 90% of its crude from the Middle East and expensive oil is seen transmitting pricing pressures into the economy and squeezing household incomes. It¡¯s a toxic condition the country hasn¡¯t faced since the oil shock of the 1970s, and if crude prices remain elevated for a prolonged period, it is seen hurting consumer demand and economic activity.

That leaves the Bank of Japan (BOJ) facing a difficult trade-off: tighten policy to support the yen and contain inflation expectations, or hold back to avoid undermining growth that helped stocks to fresh record highs last month. It also risks exacerbating fiscal concerns, which are already elevated after Prime Minister Sanae Takaichi¡¯s election victory, as a stagflation shock could prompt additional government spending.

¡°Higher oil prices reinforce the perception that the BOJ is behind the curve, which can be a continued source of yen weakness in the near term,¡± said Florian Neto, Amundi¡¯s head of investment in Asia. ¡°The main impact is that if the yen depreciates further, it erodes purchasing power for Japanese households, which are already struggling with elevated living costs. That creates a negative feedback loop¡± that could eventually weigh on corporate earnings, Neto added.

Some investors are positioning for a flattening of Japan¡¯s yield curve, a trade that typically benefits when shorter-term yields rise on expectations of policy tightening while longer-term yields are capped by growth concerns.

Kensuke Niihara, State Street Investment Management¡¯s chief investment officer for Japan, said curve flattener trades, which favor longer-dated bonds over shorter maturity debt, could perform better in the current environment....