One year ago the Japanese economy was dealt a devastating blow by a major earthquake and the resulting tsunami and nuclear crisis. In 2011 Japanese economic growth, as measured by real (constant-price) GDP, is estimated to have declined by almost 1%. There are indications the economy is now turning around. Industrial production advanced 3.8% in December, followed by a further 2% increase in January. The Japanese Ministry of Economy, Trade, and Industry (MITI) is projecting 1.7% increases in February and March. Over the 2012 calendar year the advance in GDP could well fall in the 2-3% range. Such an advance for what is still the third largest economy in the world, following some two-plus decades of stagnation (since 1990), would be an important tailwind for the global economy, and would like boost Japanese equities significantly.
Post-tsunami reconstruction is contributing to the turnaround, as is the recovery in the global economy. The most significant factor going forward, however, is the recent shift to an expansionary monetary policy by the central bank, the Bank of Japan (BOJ). After years of rejecting quantitative easing as being ineffective for promoting economic growth and having the potential to lead to runaway inflation, the BOJ abruptly changed its stance on February 14th. Following the examples of the Federal Reserve Bank of the United States, the European Central Bank, and the Bank of England, the BOJ announced its intention to pursue a policy of quantitative easing through a major program of direct purchases of government bonds. It will be purchasing nearly all of the Japanese government bonds to be issued thru the remainder of this year, thereby financing the government’s huge debt, which is equal to some 200% of Japan’s GDP.
Setting aside for the time being its concerns about possible future inflation, the BOJ also announced its determination to overcome the current deflation and set a “goal” of a 1% rate of inflation. Another objective is to achieve a depreciation of the US$/JPY exchange rate to help Japanese exporters. Markets responded positively to the BOJ moves. The yen has depreciated by some 4.4% since February 13th, and we would not be surprised to see the rate reach 100 later in the year. The Nikkei equity index has advanced by about 9%. Significant further outperformance by Japanese equities looks likely in the coming months.
Our positive outlook for Japan’s equity market is based on our assessment of the economy, noted above, and the expected positive effects of further currency depreciation. Also, we have read with interest a report by Benderly Economics on a study of Japanese corporate profits and equity-market returns. It suggests to us that if the economy is indeed turning around and the global recovery continues, Japanese corporate earnings will be strong. Also, Japanese equity valuations are very attractive.
There are clearly risks in the outlook. The BOJ may not succeed in achieving further depreciation of the currency. The global recovery could be set back by a greater than expected slowdown of the Chinese economy or further problems in Europe. The effects of higher oil prices are a major concern for Japan. They could aggravate another domestic energy issue, the supply-demand situation for electricity in the coming months. An expected total shutdown of Japan’s remaining nuclear plants in April could well lead to electricity shortages in the summer.
At Cumberland Advisors, we have added to Japan positions in our International and Global Multi-Asset Class portfolios. In view of the risks noted above, we will be monitoring developments in Japan very closely.
There currently are some 10 Japan equity ETFs available in the US market. Of these, there are four that have market capitalizations of at least $100 million. The iShares MSCI Japan Fund, EWJ, is by far the most popular. It covers the total Japan equity market. The WisdomTree Japan Hedged Equity Fund, DXJ, also covers the total market. It seeks to provide access to Japanese equities while neutralizing the yen currency risk versus the US dollar. The MAXIS Nikkei 225 Index Fund, NKY, covers large-cap shares. Small-cap shares are covered by the WisdomTree Japan Small Cap Dividend Fund, DFJ. Thus far in 2012, large caps have outperformed the total Japan market, while small caps have lagged the market.