Abstract: Japan's stock market is on a tear, backed by the Bank of Japan, now acting as decisively as the Fed in trying to drive down the value of its currency with the goal of transforming deflation into economic growth. It may work -- but what are the pros and cons for investors pondering putting money to work in Japanese equities?
The Japanese stock market has been on a tear, with the Nikkei 225 soaring some 20% in dollar-adjusted terms over the course of the last five months. That leaves U.S. investors on the horns of a dilemma: Is it worth allocating some of their gains from the U.S. rally in Japanese stocks in hopes that this will prove to be just the early innings of a similarly long-lived Japanese rally? On the other hand, by some metrics, Japanese equities aren't a bargain.
Making the task of evaluating the pros and cons of Japanese equity investing more complex is the impact of Abenomics , the program of monetary stimulus policies and proposed structural reforms initiated by Japan's recently-elected premier, Shinzo Abe. Already, Abenomics, which has as its goal propelling the Japanese economy out of deflation and toward a 2% inflation target, has been welcomed by market participants and has helped to boost investor confidence. But the country's economic policymakers still must grapple with long-term structural issues such as Japan's aging population and the fact that the country's debt load now hovers at more than 200% of GDP, as well as the global context, including environmental disputes and territorial arguments between Japan and China. Some of the issues we believe are relevant to the question of whether Japanese stocks look appealing will be as familiar as these; others will be lesser-known issues.
The Case Against Japanese Stocks
Economists generally believe that the goal of newly-appointed Bank of Japan Governor Haruhiko Kuroda -- to generate 2% inflation in Japan within two years -- is a reasonable objective, but as the Financial Times has pointed out, transforming the deflating economy (the inflation rate currently stands at -1%) into one that is reflating at a rate of 2% would drive government debt service costs from 40% of total receipts to 80%, assuming that interest rates follow the inflation rate higher in lockstep. In the 'race to the bottom', Japan appears among the leaders, as its currency tumbles and provides it with an edge in global trade.
On the basis of the ratio of price to intrinsic valuation, Japan clearly is the most richly valued market within the Developed Asia Pacific region, a group of nations that also includes Australia, New Zealand, Hong Kong and Singapore. Looking at Japan by sector, consumer staples and information technology carry the highest ratios (close to parity in valuation terms). Together, these two sectors account for a third of Japan's market capitalization, with consumer staples representing 22% and information technology another 11%.
Relative valuation considerations also argue against Japan being considered a bargain within the Developed Pacific region as whole. When compared to Australia, New Zealand, Hong Kong and Singapore, on the basis of StarMine's aggregate Price/Forward Earnings ratio, Japan lies in the middle of the group, failing to offer a compelling reason to own -- or avoid -- its equity market. Other arguments against viewing Japanese equities as attractive investments include the fact that the weaker yen makes the cost of imports -- including oil, which accounts for seven percent of Japan's gross national product, more expensive. Japan has already gone from having a surplus to a current account deficit in the last few years.
The Case in Favor of Japanese Equities
Japan's economic policies over the last 20 years have failed to deliver the outcomes that investors and the country's citizenry had hoped for, and the strength of the yen has damaged both Japanese growth and global competitiveness. But even if the Japanese government's policies to boost the rate of job creation among younger workers are only partially successful, they still would stimulate consumption and boost tax revenues. Currently, the unemployment rate among younger workers has been reported at around 10%, more than double the national unemployment rate, and economists will be looking for evidence that this is falling over the coming months. Certainly, there is hope that the proposed monetary policy reforms will be different, however, and the recent weakness in the yen already has helped to jumpstart a recovery in Japanese equities, (see chart, below).
Within the U.S. market, there has been considerable speculation about the prospect of a "big rotation" out of bonds and into stocks; in Japan, however, just such a rotation may already be underway. Investors widely view the Bank of Japan's recent announcement of its plan to buy longer-term Japanese government bonds (JGBS) as a move to replicate the actions by the U.S. Federal Reserve, which has driven investors out of lower-yielding and 'riskless' government bonds and into risk assets, such as stocks, as the yield advantage from government bonds vanishes. The chart below, which compares the recent performance of the Japan 10-year government bond compared to the Nikkei 225 Index, shows the extent to which the slide in yield on government bonds has been accompanied by a stock market rally in Japan.
In the United States, equity investors have found the 'Bernanke Put' -- the conviction that the Federal Reserve will step in and buy bonds whenever the situation appears to demand it, with the quantitative easing policies this has produced named in honor of Fed Chairman Ben Bernanke -- has been rewarding. Now, a similar strategy may be appropriate for Japanese equity investors, with 'Don't fight the Bank of Japan' replacing the U.S. mantra of, 'Don't fight the Fed'. But the bottom line remains the same in the eyes of economists: that central bank policies will continue to support equity markets in both countries.
As far as Japanese equities are concerned, the recent rally in response to these policy initiatives has propelled the I/B/E/S forward P/E ratio for the TOPIX index to the highest level it has recorded since July 2010. While the Tokyo benchmark index current trades about 14.2 times forward earnings (shown in the blue line on the chart below), that still remains below the 10-year median of 16.3 (reflected by the orange line in the chart below) and thus represents a final argument in favor of Japanese stocks, at least by relative valuation standards. Looking forward, the critical question becomes whether analysts will raise or lower their earnings estimates in the coming months or years, moves that would force investors to readjust that relative valuation calculation.
Approach With Caution?
Some investors may find that taking a hedged approach to Japanese equities may be appealing. One example of such a strategy is the WisdomTree Japan Hedged Equity Fund (DXJ), which seeks to neutralize yen/dollar movements and that has generated a 35% return in the five months ending March 25, 2013 (see chart the red line in the chart below), compared to 17.6% for the iShares MCSI Japan Index (EWJ), which doesn't hedge currency exposure. (The latter's performance is reflected in the blue line on the chart below.) Trading volume in the DXJ has remained strong since mid-December.
Source: Thomson Reuters Eikon
Japan may not seem like much of a bargain today in investment terms. Not only has the Tokyo market already rallied, pricing in some future good news, but the country's economy offers plenty of structural headwinds and the probability of bills to pay down the road as a result of the new policy proposals. But just as the U.S. stock market has responded favorably to the successive rounds of quantitative easing in the United States, dating back to 2009, so, too, financial markets appear to be rewarding Prime Minister Abe and his policies with improved confidence and an embryonic rally. Will this morph into a lasting rally? The jury is out, but clearly there now is at least a case to be made in favor of Japanese stocks.