Japan: Market Top or Entry Point?

This year foreign investors have plowed almost $80 billion into Japanese equities, which have been leading global markets. By Wednesday, May 22, the market was up 46% year-to-date. Suddenly late last week the Japan market tumbled, with the Nikkei falling 7% on Thursday, May 23rd. This was the largest one-day plunge since March 2011, the time of the earthquake, tsunami, and Fukushima nuclear meltdown. Some additional, more modest, easing occurred on Friday, followed by a further 3% drop Monday. Today, Tuesday, May 28th, the Nikkei recovered by 1.2% as global markets rise. Do these moves signal a top for Japanese equities, or is this a welcome short-term correction in a market that has gotten a bit ahead of itself? Is this pullback an entry point to a market that promises further outperformance?

There are several reasons the market pullback occurred when it did. Global equity markets were in retreat because of softer than expected economic data out of China and concerns that the US Federal Reserve might start tapering off its bond purchases (quantitative easing) sooner than expected. We don’t share the latter concern but do agree that any weakness in the Chinese economy would have global implications. It was not surprising to see Japanese equities retreat along with other major markets. But we need to look further to understand the extent of Japan’s market decline.

The most likely contributing factor was the extreme volatility in the Japanese government bond market, where 10-year yields surged to almost 1% before retreating back to 0.85%. The bond market was evidently confused about the Bank of Japan’s policy and the communications of BOJ’s new Governor, Haruhiko Kuroda. The stated policy is to keep interest rates very low through massive purchases of bonds to encourage investors to move out of Japanese government bonds and into Japanese equities and foreign assets, to increase inflation expectations, and to revive the economy. Kuroda confused market participants by acknowledging that, to the extent the policy succeeds in reviving the economy, interest rates will tend to rise. This was viewed as being contradictory with the low-interest-rate policy, and yields spiked. It is not, however, a contradiction if one takes into account the time factor. Low rates now encourage growth, which eventually will have the effect of raising rates. The BOJ will be seeking to stabilize the bond market by flexibly adjusting its bond purchasing program and fine-tuning its communications skills.

No doubt instability in the government bond markets and confusing communications by the BOJ have worked to undermine equity investor confidence. The communications difficulty faced by Kuroda was underlined by news today that, in the latest meeting of the BOJ, “a few” board members said that swings in financial markets are due to perceptions that the BOJ has conflicting goals. Moreover, they questioned the feasibility of reaching the 2% inflation goal.

The equity market correction may well continue a bit further, but we believe the upward trend in Japanese equities will resume as the massive policy stimulation takes hold. Note that one element of the Bank of Japan’s stated policy is to double its direct investment in the total Japan market ETF, MSCI Japan (EWJ), to 3.5 trillion yen ($35.2 billion). Stimulating the equity market is a clear policy objective. Accordingly, the pullback represents an entry point to participate in a market that may outperform, not only in the coming months, but possibly well into 2014. Following more than two decades of underperformance, there remains ample room for a further recovery in this market if, as seems likely, “Abenomics” is successful in promoting growth in the Japanese economy.

In our next Japan note we will discuss prospects for the yen and why we continue to prefer Wisdom Tree’s currency-hedged Japan equity ETF, DXJ.

About Bill Witherell 24 Articles

Affiliation: Cumberland Advisors

William Witherell joined Cumberland Advisors as Chief Global Economist in November 2005 and became a Portfolio Manager in December 2005. He is also a Senior Consultant for Finance and Corporate Governance to the Organization for Economic Cooperation and Development (OECD). From 1989 through September 2005, he was OECD’s Director for Financial and Enterprise Affairs. He joined the Secretariat of the OECD in Paris, France, in 1977.

Dr. Witherell is a graduate of Colby College and holds M.A. and Ph.D. degrees in economics from Princeton University. Dr. Witherell began his career as a business economist with Exxon and Esso Eastern, from 1967 to 1973, where he held positions in the economics, treasury, and corporate planning functions. He moved to the international economic and financial relations field in 1973, with positions first in the U.S. Department of State and then in the Department of the Treasury, from 1974 to 1977, as Director of the Office of Financial Resources and Energy Finance.

Dr. Witherell currently resides in North Grafton, Massachusetts. He is a past Chairman of the International Roundtable of the National Association for Business Economics, and a member of the Boston Economic Club and the Westborough, MA Rotary Club.

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