The Japan Problem

Japan has been a thorn in portfolio strategy's side for over a decade, and more of the same is on tap for the foreseeable future.

As the world's second-largest economy after the U.S., with a stock market capitalization to match, Japan looms large as an influence in the global economy and the capital and commodity markets. Unfortunately, the influence has been largely negative since the early 1990s on matters of asset allocation.

A summary of the trouble can be found by comparing the MSCI Pacific Index to its counterpart that's identical save for excluding Japan's equity market. The disparity in annualized total returns (in $ terms via Morningstar Principia) for the 15 years through January 2009 is striking:

•MSCI Pacific -1.4%
•MSCI Pacific ex-Japan +1.8%

Excluding Japan has clearly been a boon to allocating assets in Asian markets, and to global equity allocations generally. To the extent you lightened up on the Land of the Rising Sun over the past 15 years, the better your investment results. That wasn't necessarily true if you engaged in tactical asset allocation with Japan as a distinct variable, but it held true for a buy-and-hold investor with a global equity position.

As always, the strategy you should have embraced is unambiguous. Deciding if it'll work in the future is something else. It's tempting to simply steer clear of Japan, as many investors have done in global equity mandates over the years. It's hard to imagine many investors will act much differently going forward. But avoiding Japan as a general rule opens up a can of strategic worms, and so no one should rush to judgment.

Simple answers may look appealing, but they're not always the slam-dunk they appear to be when it comes to designing and managing a multi-asset class portfolio.

A few observations:

* Japan's current economic outlook, unsurprisingly, has fallen on hard times, along with the rest of the global economy. The immediate cause of the latest round of Japan problems is suggested by BCA Research, which recently advised that "the Japanese manufacturing sector has collapsed, and further production cuts lie ahead."

* Japan's equity market is currently 10.8% of the total global equity market capitalization, according to Standard & Poor's. That compares with the current U.S. equity market weight of 43.2%.

* The S&P Japan BMI equity index's total return is -41.2% for the 12 months through last night. That compares with -47.6% for S&P Asia Pacific BMI over the same period (both in $ terms), -48.0% for the S&P U.S. BMI and -51.7% for the S&P Global BMI index, which represents the entire world's equities.

Comments

[Mark Bern:]

Looking at the last paragraph of the article, it would appear that the Japan market has done far better than the rest of Asia over the last year. It has also outperformed the U. S. and the world in aggregate.

Also, try looking at the following quote a little diferently: "the Japanese manufacturing sector has collapsed, and further production cuts lie ahead." I suspect that one could substitute the name of just about any nation with a significant manufacturing base for "Japanese" and the statement would be accurate. The point being, Japan has troubles just like the entire global economy does. However (and this is taking a really big leap), since the Japanese stock market is outperforming most other major markets during what may be the worst part of what may be the worst economic downturn post-WWII, might we not assume that their economy may have turned the corner from the lost decade and be stronger now?

Also, Japan's economy had strengthened considerably riding on the surge in economic growth from China and other developing Asian countries. If China leads the world out of this recession (or whatever you want to call it) might that not bode well for Japan as well?

Mind you, I'm not about to rush out and buy a lot of Japan-based stocks right now. I'm just pointing out that while the assumption that leaving Japan out of Asia allocations was a smart play then, the facts as presented don't justify leaving it out in the future.

Mar 10 12:13 PM

[bricki:]

The difference between Japan and many other nations is driven by its demographics. Japan has the oldest average age population in the world, and the lowest birth rate. It is also a society intolerant of immigrants. The result is a declining population.

All of this spells weak internal demand. Thus Japan, perhaps more than any other nation is dependent on external demand for economic growth. In the current economical situation this spells continuing economic maliase for the Japanese economy unless they figure out how to stimulate growth in their trading partners.

Mar 10 01:15 PM

[Chris B:]

I agreee bricki. With weak internal demand, Japan's economy is dependent on exports. When the US and Europe have a recession, they buy a lot fewer Japanese imports, simple as that. Thus, Japan is destined to be somewhat more volatile than more diversified economies like the US or Europe.

Husker Mark, good points, but you didn't mention Japan's monetary/fiscal policies. After all, that's how their export-based economy somehow managed to stagnate through the booming 90's. If they don't reform their financial sector and control deflation, we can expect similar results in the 2010's, whether the 10's are booming or not.

Years of hands-off policies have left the Japanese with zombie banks and national debt levels that are ironically greater than what the cost of dispatching and reforming those banks in the first place would have been. Yet, their high debt levels are now discouraging them from spending any money to control deflation, encourage lending, or stimulate consumption or production. This penny-wise, pound-foolish ideology is dominant in Japan, whereas most Western citizens are demanding immediate, overwhelming action.

More importantly, the business case for Japanese manufacturing has completely changed in the last 2 decades as (a) Japan has become one of the highest-cost locations in the world, and (b) China, next door, has emerged with much lower costs. Japan's best hope is to become a regional finance, technology, and service industry center. With similarly competent developed neighbors to the north and south, that's a longshot.

At similar valuation levels, I'll go with South Korea (EWY), Brazil (EWZ) and Australia (EWA) before I go with Japan (EWJ). Fiscal/monetary policy is the key.

Mar 10 01:40 PM

[Jolly_Rancher:]

So why is the yen so strong given Japan's condition, high debt and "off a cliff" economy?

Mar 10 01:58 PM

[Aristophanes:]

Japan's key problems are social and demographic. They built superfluous airports, bridges and roads but really needed to build affordable family size housing and daycare centres to boost their birth rate. Japan more than any Western nation has the worst case of capital misallocation. The current governing party is utterly beholden to those who pour concrete so, once again, the stimulus they are trying is to pour more concrete. You could swing a dead cat on some of their rural 4-lane roads and not hit a car for hours.

Mar 10 02:23 PM

[User 372317:]

The cases made above have all contributed to the problem, but there is also the spending habits of the populace. The savings rate in Japan is far above those of the US and other Western nations. Getting the populace to open it's purse strings is a major issue. Building cheap homes instead of highways and bridges sounds like it would have helped but that is only if you don't take into account the mindset of many Japanese after the asset inflation that led to the Lost Decade. Many Japanese are very hesitant to buy homes even if they can afford it due to losses their parents suffered when asset values tanked in the early 90's. Building track housing would have been a massive gamble in the mid-90's.

Mar 10 11:16 PM

[Shiva:]

When a stock index touches its 26 year low, its very easy to ignore it in your portfolio allocation.

Mar 11 09:53 AM

[JudeJin:]

watch out for japan's zombie banks! they are as rotten as citibank!

Mar 12 02:19 AM