Abenomics: How Stable Are Japanese Markets?

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 |  Includes: DXJ, EWJ, FXY, NKY
by: David Guarino

As the Bank of Japan attempts to end roughly two decades of stagnation through vast sums of monetary stimulus, investors need to be cautious of the "hot money," which tends to chase these impressive growth stories. On May 30, the Bank of Japan announced it will now be purchasing 7+ trillion yen worth of Japanese Government Bonds. Since the market caught wind of Prime Minister Shinzo Abe's possible nomination in November of last year, the Nikkei 225 never looked back.

Upon his election and the BOJ's monetary policy announcements, we have witnessed a tremendous increase in Japanese equities. As you can see in the chart below, "Abenomics" has successfully been able to implement stage one and two of turning the country around, increasing assets prices and reducing the value of the yen. Step three is going to be the most challenging, as structural reform will need to be put in place. Unfortunately this final step has historically proven to be the most difficult to implement. We will likely learn more about Abe's plans regarding deregulation and fiscal policy in the coming weeks.

The story of Japan's economy is one which keeps economist up at night debating the possible outcome. With an extremely weak currency, which has historically been used for carry trades, inability to create inflation, aging demographic, and debt-to-GDP ratio that makes America look fantastic (some estimate it at 250%), the debates on this country can take various forms. While this article could take a deep dive into any of these topics, I will try to focus on the new risks involved with owning Japanese equities or the Japanese yen at these new price levels.

Capital Flows

So how much capital is moving into Japanese stocks? Year to date through May 19, net foreign equity purchases in Japan have reached roughly $80 billion. This amounts to about 10% of the increase in market capitalization of the index through the period. Compare this with $11.3 billion in the same period last year and that "bubble" word starts coming to mind. If you look at net foreign equity purchase over the past five years (see chart below) the magnitude of 2013's massive rally begins become alarming. While I am not calling a top in Japanese stocks, I think it is prudent to evaluate the heightened level of risk embedded in these securities at current price levels.

Click to enlarge

With Japan having a history of yen carry trades, one would assume a large amount of these equity purchases are being funded by borrowed yen. The benefits of borrowing with a depreciating currency and investing in an upward trending stock market can truly show a manager's genius when done correctly. However history has proven time and time again that when carry trades unwind, the selling can be exacerbated as investors sell stocks and buy back the currency. This poses a substantial risk not only to Japanese financial markets, but markets worldwide. A few weeks ago when the Nikkei sold off over 7% (with an unknown catalyst), we witnessed a contagion effect sweep across the globe into Europe and concluding with American markets.

The Bank of Japan released its Statement On Monetary Policy on May 22nd which reiterated my points above:

"Regarding risks, there remains a high degree of uncertainty concerning Japan's economy, including the prospects for the European debt problem and the growth momentum of the U.S. economy as well as the emerging and commodity-exporting economies."

Smart money has already had a terrific return in Japanese stocks this year and one has to start asking when they will begin taking profits off the table (if they have not already).

Gaining Exposure

Given the complex financial statements of certain Japanese companies and accounting rules, which differ from the ones that govern stocks traded in America, investors are unlikely to spend a great deal of time evaluating individual Japanese securities. Thankfully there are numerous ways for investors to gain exposure to Japanese securities through ETFs. I will highlight a few of the most actively traded.

One of the most liquid ETFs, which gives exposure to Japanese stocks is the iShares MSCI Japan ETF (NYSEARCA:EWJ). Another option for investors who want exposure to Japanese stocks without the fluctuations of the yen is the WisdomTree Japan Hedged Equity ETF (NYSEARCA:DXJ). Take time evaluating both investments before looking to invest as the portfolios hold different stocks and weight securities differently. Gaining exposure to the Nikkei 225 index can be accomplished through the Maxis Nikkei 225 Index ETF (NYSEARCA:NKY), however I would caution investors as this is the least liquid of the three mentioned (based upon average daily volume).

For investors looking to trade the Japanese yen directly, CurrencyShares has an ETF to track the performance (NYSEARCA:FXY).

Conclusion

Given the rally in Japanese equities one may ask whether or not they have missed out on the rally or if there is still room to run. While only time will truly provide an answer, my personal opinion is one of optimism and continued growth. The financial markets worldwide are dependent on monetary easing and the largest central banks across the globe continue to deliver (U.S. Federal Reserve, Bank of Japan, Bank of England, European Central Bank). No matter which developed country you evaluate, the race to debase your currency is in full effect. Until we begin to see hints of unwinding these accommodative policies, it appears equity markets still have upside potential.

However I caution investors who are willing to invest in Japanese securities to buckle up and get ready for some volatility. As we witnessed on May 22, when the Federal Reserve Minutes showed possible signs of unwinding asset purchases, markets do not respond kindly. I think it is safe to assume that this kind of restrictive language from any central banker will cause selling pressure in the home country. Consider your investment goals and objectives before initiating a position in any of the securities mentioned and please remember that the value of investments in equity securities will fluctuate in response to general economic conditions and to changes in the prospects of particular companies and/or sectors in the economy.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.