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The Japanese economy is the third largest in the world after the United States and China. Currently, it is suffering from deflation and budget deficits. Consumer price index fell 0.6% compared to a year ago. Consumers are refusing to consume, corporations are holding back on investments and banks are sitting on cash. The Japanese yen has significantly appreciated during the past 12 months. The usd/jpy exchange rate was 95 last year, and it sits at nearly 82 today. This is starting to impact the growth rate of its exports. Export volume grew by 2.3% y-o-y in January, after rises of 9.2% in November and 11.4% in December. Japan’s trade deficit was 471.4 billion yen as of January.

Another problem facing Japan is that oil prices reached the highest point of the last two and a half years on fears that the disruptions in Libya may spread to other Middle East oil producers. Japan consumed 5.033 million barrels per day (bbp/d) of oil in 2010, making it the second largest petroleum consumer in the world, behind the United States. Although a stronger yen lessens the impact of high oil prices, there is no magic bullet that can protect the Japanese people from a growing budget deficit and public debt. The levels of public debt have remained extremely high, approaching 200% of GDP. There are some hedge funds, i.e. David Einhorn’s Greenlight Capital, which made long-term bets that interest rates in Japan will increase significantly.

In response to these developments, S&P lowered Japan's long-term credit rating to AA-minus from AA in January, and recently Moody's changed its outlook to negative from stable. Moody’s expects a debt and currency crisis in the medium term if the government policies are not enough to rein in public debt.

The iShares MSCI Japan Index Fund (NYSEARCA:EWJ) increased by 15.5 % in a year, 9.4% in last three months. The iShares MSCI Japan SM Cap (NYSEARCA:SCJ) gained 19.9% in a year, 12.5% in last three months. And the Wisdom Tree Japan Small Cap Fund (NYSEARCA:DFJ) went up 15.6% in a year, 11.3% in the last three months. SPDR Russell/Nomura Prime Japan ETF (NYSEARCA:JPP) gained 15.7% in a year, 9.9% in the last three months.

Unfortunately the Japanese ADRs that trade in the U.S. weren’t as lucky. Sony (NYSE:SNE), Canon (NYSE:CAJ) and Panasonic (PC) underperformed the Japan Index Funds. Toyota (NYSE:TM) and Honda (NYSE:HMC) managed to deliver better returns, thanks to spectacular performance since the beginning of November. The increase in Japanese currency helped broad market ETFs perform well, but it hurt the multinational companies that depend mostly on exports. If the trend in currency markets doesn’t reverse, Japanese ETFs will keep performing better than the Japanese ADRs.

Source: Will Japanese ETFs Continue to Outperform Japanese ADRs?