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Major reforms in Japan, including the creation of special economic zones and a commitment to escaping deflation, are leading some to wonder what’s in store for the world’s third-largest economy. Dodd Kittsley takes a look at the fundamentals and explains why there’s value to be seen in Japan.

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Japanese equities were a favorite among investors in 2013. This year, it seems the appeal is starting to cool. March saw $0.7 billion in Japanese equity outflows, representing the first monthly redemptions in two years. The chart below illustrates ETF flows by region since January 2013; the red portion represents Asia Pacific flows, which are primarily driven by Japan equity exposures.

The outflows are due in part to this month’s planned sales tax increase, which is expected to spark an economic contraction in Q2. Still, we think investors may find value in Japanese equities.

As my colleagues note in Rising Sun, Setting Sun, a special report from the BlackRock Investment Institute, there are several key events and processes that can help Japan to escape economic stagnation.

  1. Wage growth. This is a necessary part of restoring inflation. Wages are not keeping up with rising prices, which is taking a toll on consumer sentiment. We continue to monitor spring wage negotiations between large Japanese companies and unions.
  2. Private sector cooperation. Prime Minister Shinzo Abe’s efforts to evade deflation and revive the nation’s economy, (referred to as “Abenomics”), have thus far helped Japan find more stable ground. Monetary easing and fiscal consolidation have coaxed Japan’s economy toward stability; the private sector must take it from here.
  3. Bank of Japan (BoJ) support. The nation’s central bank seems committed to its goal of reaching 2% inflation, aiming to continue its monetary easing plan for the next two years or so.
  4. Lower valuation of the Japanese yen. As Russ Koesterich notes in his latest Investment Directions, “global sentiment remains a major source of risk for both the yen and Japanese stocks, the United States’ and Japan’s divergent monetary policy paths will likely place downward pressure on the yen.” This should, in turn, help support corporate earnings.

The report also points to the potential for Japan’s equity market to be bolstered by local investors. The nation’s $1.26 trillion Government Pension Investment Fund (GPIF), which is the world’s largest public pension fund, has revised its investment allocation by trimming bond exposure in favor of equities. As of April 1, 2014, the fund’s core allocation limits its exposure to Japanese stocks to a maximum of 18%, and holds 17% as of December. The GPIF’s Investment Committee would have to agree to raise its exposure to equities, an action that could lead other institutional Japanese investors to follow suit.

We are presently overweight Japanese equities, as their valuations are attractive relative to U.S. stocks. If you’re looking for exposure to Japan, there are several ways to get it:

  1. Currency hedged. Currency Hedged ETFs provide exposure to Japanese stocks while seeking to minimize exposure to the yen. Because a weaker yen can take away from performance – and Russ K expects that the yen will remain weak – many investors have turned to currency hedged ETFs to get exposure to Japan. For more on the importance of currency hedging, read my Blog post on the topic. Related iShares ETF: iShares Currency Hedged MSCI Japan ETF (NYSEARCA:HEWJ).
  2. Large- and mid-cap. Many large-cap stocks are exporters, and can benefit from a weaker yen. Look for funds that provide broad and diversified exposure to well-established Japanese large- and mid-cap companies. Related iShares ETF: iShares MSCI Japan ETF (NYSEARCA:EWJ).
  3. Small-cap. International small-cap stocks and Japanese small cap funds can provide further diversification to a portfolio as they are less correlated to global markets and more linked to the local economy. Related iShares ETF: iShares MSCI Japan Small-Cap ETF (NYSEARCA:SCJ).

You can follow Japan’s major economic indicators with this interactive graphic.

Sources: BlackRock ETP Research; BlackRock Investment Institute

Dodd Kittsley, CFA, is the Head of Institutional Product Management and Consulting for iShares at BlackRock and a regular contributor to The Blog. You can find more of his posts here.

International investing involves risks, including risks related to foreign currency, limited liquidity, less government regulation and the possibility of substantial volatility due to adverse political, economic or other developments. These risks often are heightened for investments in emerging/ developing markets, in concentrations of single countries or smaller capital markets. Small-capitalization companies may be less stable and more susceptible to adverse developments, and their securities may be more volatile and less liquid than larger capitalization companies.

The iShares Currency Hedged ETF’s use of derivatives may reduce the Fund’s returns and/or increase volatility and subject the Fund to counterparty risk, which is the risk that the other party in the transaction will not fulfill its contractual obligation. The Fund could suffer losses related to its derivative positions because of a possible lack of liquidity in the secondary market and as a result of unanticipated market movements, which losses are potentially unlimited. There can be no assurance that the Fund’s hedging transactions will be effective.

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Source: Abenomics Revisited: Finding Value In Japan