Japan: Sunset Of The Rising Sun

Includes: DXJ, EWJ, FXY, SPY
by: The Fortune Teller


Japan is a fascinating country with a hard to explain economy.

Back in the days, I was long DXJ and short the yen. Nonetheless, a lot of water has flown under the bridge (and the rising sun) since then.

I've sold my positions about a year ago; a bit too early but, more importantly, not too late….

The reasons behind the sale back then are as – and perhaps more - valid today.

Japan - Admire the country and its history, beware of the economy and its financial markets!


In November 2014 I was extremely surprised to realize that there is very little analysis in SA when it comes to the WisdomTree Japan Hedged Equity Fund (NYSEARCA:DXJ). The DXJ was until very recently a much better instrument to be exposed through to Japan than the much popular iShares MSCI Japan ETF (NYSEARCA:EWJ).

Few months later, about a year ago, and after another run up (see below) I've sold my positions, both my long DXJ as well as my short position on the Japanese yen (NYSEARCA:FXY).

Even back then, as my article proved, the DXJ already had outperformed the EWJ so there's no wonder that alongside the Japanese yen continuous decline (since then) the gap only got wider.

Nonetheless, since the beginning of 2016 the Japanese yen, aka "JPY", has stopped playing along. YTD, it has already strengthen more than 10% against the US dollar, aka "USD" or "USDX" (=The US Dollar Index is a measure of the value of the US dollar relative to majority of its most significant trading partners).

Adding to this a major flow of very disappointing news, combined with Japan's most severe problem - the demographic situation - causes me to be concern, to say the least, about Japan as well as about maintaining long exposures to the Japanese economy.

Performance of Japan-Related Instruments since November 2012

My initial article about Japan looked at the DJX, EWJ and FXY returns since 11/1/2012 so I'll keep following its footsteps. It's quite stunning to see to what extent has the DXJ outperformed the EWJ for as long as the Japanese yen, represented here by the FXY, had weaken. As long as the red line was in decline - the DXJ was on top. As soon as the red line started an incline, around mid-2015, the DXJ started to outperform.

Also worthwhile mentioning is the out-performance of the DXJ over the S&P500 (NYSEARCA:SPY) until about two months ago. Since the SPY started its most recent rally the divergence between this pair is quite amazing.

DXJ Chart

To make things more clear, here is the exact same chart but this time running over (only) the past year, i.e. since I got out of my positions. The trend (red line up - blue line down) is looking way more sudden and way more dramatic when the time-frame is much shorter.

While the S&P500 gained over 10% since its through on 2/11/2016, the DXJ remained more or less flat for the same period.

DXJ Chart

It's no wonder then that:

(1) Getting out of my long DXJ and short yen positions during April 2015 was way too early as I could have cashed in another 5% (on the DXJ) to 10% (on the yen). Nevertheless, cashing out more than 4-5 months later would end up with a way more painful results. The longer I would have stayed in those positions - the larger would have been the losses.

(2) The Japanese economy looks awful over the past few weeks due to the yen that has strengthened dramatically since the beginning of 2016. Thankfully, that didn't hurt me personally as I got out in time but it surly hurts the Japanese economy that, unlike me, is unable to get out of its decades-long imbalanced position. That's bad and that may turn to be much worse over (an upcoming short period of) time.

The leading Japanese equity index, the Nikkei225, is perfectly reflecting on this very rough period that the economy is going through. Looking at the below chart, showing the YTD performances of the world's top equity markets, the Nikkei225 is clearly lagging way behind both the S&P500 as well as the German Dax index. Interesting for itself, the Dax, i.e. Europe, is lagging significantly behind the S&P500, i.e. the US. The current order of economic strength among the world's top three economies is obvious.

^GDAXI Chart

From Bad to Worse: Top Financial Headlines Out of Japan over the Past Month Alone

How can one remain positive on Japan when you look at the past month headlines? The past month had so many bad news that may be sufficient for an entire year. Here goes:

  1. Negative rates (not a last month news for itself) and possibly exempting about $90B placed into short-term funds (that's last month news) due to fear of those monies departing into bank deposits. What's so wrong about it? Well, they wish this sum to keep being investing and keep feeding the pumping machine, aka "Securities are good, deposits are bad".
  2. The BOJ governor said that no more interest rate cuts are expected…for now… Japan's economy heavily dependent on the BoJ maintaining its long-standing loosening monetary policy. Therefore, such a statement by Mr. Kuroda himself is almost as severe as cutting a patient off his oxygen supply through a ventilation machine…
  3. Similarly, keeping its monetary policy steady, is almost as bad as not cutting rates. Reading further into it - Exports and production "have been sluggish due mainly to the effects of the slowdown in emerging economies," while public expectations of future inflation have "recently weakened" - one can't wonder what else is needed to loosen even further and what is causing the delay.
  4. Asset managers have poured tons of money into Japan over the past couple of years and most prospects, even as I write, are quite positive. Therefore, hearing of a top-ranked hedge fund betting against Japan is not only unusual but it may be a kind of an early alarm.
  5. Historically, Japan is totally dependent on its exports. Dropping for the fifth month in a row, exports are not only drawing a very gloomy picture when it comes to the economy's most important factor, but they also hint that they may be dipping into its fourth annual recession.
  6. The Japanese yen has stopped playing along. Quoting from a Bloomberg article: "The tailwind from the weak yen has gone. We can't help but hold a pessimistic view on the outlook for exports," said Atsushi Takeda, an economist at Itochu Corp. in Tokyo, said. "Domestic demand won't be dependable at all, and the same goes for exports. I can't deny the possibility of another economic contraction this quarter.""
  7. …and the Japanese yen is actually expected to start playing against the BoJ hopes… The USD/JPY exchange rate, following a more dovish Fed, is going lower. The team at JPMorgan sees USD/JPY falling all the way to ¥103 by year's end; that's almost 10% from where it was a month ago.
  8. Industrial output fell sharply in February, underscoring fragile factory activity due to sluggish demand both domestically and internationally. This is the biggest month-on-month drop since March 2011, when a devastating earthquake crippled the country's supply chain.
  9. The BoJ has published a very gloomy Tankan survey. According to the survey, big manufacturers' business sentiment is at its lowest level in nearly three years, and it's expected to worsen in the coming quarter.
  10. The Markit's Flash Manufacturing PMI, coming in at 49.1, didn't do any better to help lift sentiment.

I've recently published an article where I've shared with readers my very personal most recent journey: A period of ten weeks through which I've lost ten kilos of my body weight. The article describes how losing body weight assists me in gaining portfolio weight. Metaphorically, this-current article could have been about a different journey: A period of ten days in which Japan has recorded ten pieces of very disappointing news.

Japan is very famous for its sumo heavy-weight wrestlers. Sumo is a national sport where the rikishi (wrestler) attempts to force another wrestler out of a circular ring (dohyō) or into touching the ground with anything other than the soles of his feet. While I was losing ten kilos of my body weight, it seems that the giant (BoJ) sumo lost his balance and has lost much of his weight and credibility...

The Biggest Problem of Japan Can't Get Solved by Monetary Easing

Japan's main and long-standing problem is the demographic situation."Catastrophe" is one of the words most frequently used to describe Japan's demographic situation: an aging society full of sexless couples having fewer and fewer babies. Fertility is below replacement level and births are being delayed. Although Japan's total fertility rate is officially up from a trough of 1.26 children per woman in 2005 to 1.42 in 2014, it's still very much questioned.

Unfortunately, Japan isn't alone in this battle but it's definitely the unhappy leader and its fight seems to be way too little, way too late. As a matter of fact, the demographic situation is a worldwide issue and a great deal of concern for future generations. Take a look at the chart below which shows very clearly that we're about to witness a mind-blowing demographic shift, a shift which is unprecedented in human history:

Within a few years, just before 2020, there are about to be more elderly people (ages 65 and over) than young children (under the age of 5)!

US Census Bureau

According to a recent report by the US Census Bureau these two age groups will continue to grow in opposite directions: The proportion of the population ages 65 and up will continue to increase, while the proportion of the population ages 5 and under will continue decreasing. In fact, according to the Census Bureau, by 2050 those ages 65 and up will make up an estimated 15.6% of the global population - more than double that of children ages 5 and under, who will make up an estimated 7.2%.

Japan is a "leading force" when it comes to this demographic change simply because it has started with it decades ago. Unfortunately, this is something that no monetary policy in the world can solve, regardless of its size.

Size matters but someone should have told this ages ago to the Japanese people, not to Mr. Kuroda; by doing so, they may have been in no-need loosening (meteorically) now what they could have loosened (physically) long ago…

What's Next?

The Asia-Pacific, as a whole, was one of few things that may turn bad that I've named. Unlike China, for example, Japan wasn't a singled out, specific, threat there. Similarly, Japan wasn't part of my most recent warning signs that investor shouldn't ignore. Nonetheless, things have changed quite dramatically over the past few weeks - as shown by the past month thread of news - and even since I've wrote these two articles. Japan has now, in my opinion, "earned" a place as a warning sign and I'll be watching it carefully and more closely as we move forward.

Can the authorities do something to tackle those burning issues? I strongly doubt it.

Sure, the BoJ may keep pouring money into the economy as well as reduce the negative interest rates further (despite the recent "pausing" announcement). As a matter of fact, the minutes of the BOJ's January meeting, where the central bank adopted negative rates, showed that officials have explored the possibility of expanding the already-at-record asset purchases before they eventually decided on the negative rates option. We will probably get a larger doze of both cures, i.e. a rate cut combined with an expansion of the QE. There are more recent sources supporting this view.

Like a terminal disease, at some point comes a time to let go and understand that treatments won't and can't do any better no more. Don't get me wrong, I don't expect the BoJ to give up but I do think that it's time to stop pumping more drugs to the dying patient. It's time to (1) think about improving the life of the patient as much as possible so he suffer as little pain as possible, and (2) since (luckily) it's not real death and life we are talking about - ensure that the sun will be rising (again) in a decade of two down the road.

It's time for the BoJ to think about the (distant) future and not about the (can't be saved) present!


Japan is very complicated economy as much as it is a most fascinating country.

From a pure academic point of view, Japan is a miracle that is operating and functioning against the common economic laws. The sad thing is that miracles tend to fade away and so is the miracle called Japan's economy. Surviving a couple of mega disasters and being able to rise from the ashes, it seems that Japan will be a victim to its inhabitants' nature rather to (the forces of) Mother Nature.

Over the last couple of years investors have experienced some very nice rides on various periods through a range of Japan-related trading instruments that are available. Nonetheless, it seems like the "Land of the Rising Sun" may be entering into a new period of sunset.

Disclosure: I/we 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.