Japan On Track To Outperform As The BOJ Defends 0.100%

by: David Kotok

By Bill Witherell

Japan's central bank, the Bank of Japan (BOJ), confirmed at last week's meeting that the recovery in the Japanese economy remains on track. It decided to leave policy unchanged with respect to its short- and long-term interest operations. The BOJ did extend for one year its loan support program for financial institutions. There was no mention of the bank's ETF purchasing program, which presumably will continue unchanged.

The BOJ calls its current policy "quantitative and qualitative monetary easing (QQE) with yield curve control." That policy includes the bank's intention to keep the 10-year rate on Japanese government bonds (JGBs) around 0%. The market interprets this objective to mean the BOJ will defend a range of -0.100% to+ 0.100%. Rising rates globally are likely to make this objective increasingly challenging as events at the end of last week demonstrated.

The BOJ has made clear it is not tapering its asset-buying program at this time. The Bank stated that net JGB purchases will continue at the annual rate of about 80 trillion yen. Doubts about the continuation of this program were stimulated by President Trump's accusations that Japan is manipulating its currency. These were understood to be an implicit attack on the BOJ's quantitative easing policy. That policy has been successful in stimulating Japan's economy and is similar to the policy that has been followed by the US Federal Reserve, the European Central Bank, and other major advanced-country central banks.

At the market's close on February 2, following the regular monthly auction of 10-year JGBs, the rate was 0.110%. The next day the BOJ decided it was necessary, despite Trump's complaints, to defend its 10-year yield peg. After the usual open market operations in the morning, the 10-year JGB yield rose as high as 0.150%. The BOJ stepped in at the beginning of the afternoon session and offered to buy an unlimited amount of JGBs in the 5-year to 10-year maturity range at a fixed yield of 0.110%. That action proved to be effective with the 10-year yield closing at 0.095%.

It is notable that the BOJ Monetary Board raised its GDP forecast last week. Growth in the current fiscal year was lifted to 1.4% from 1.0%. The GDP growth forecast for FY17 beginning April 1 was raised to 1.5% from 1.3%, which would be a strong "above-potential" growth rate for the aging Japanese economy. The forecast for FY18 is a somewhat slower 1.1 growth, which is still higher than the bank's previous forecast for that period. The core consumer price index is forecast to rise at a rate of 1.5% in FY17 and 1.7% in FY18. These figures would be well above the -0.2% deflation estimated for the current fiscal year and also about double the consensus forecasts for the next two years.

In his statement following last week's meeting, BOJ Governor Kuroda noted as a positive element that the Trump administration "… is generally seen as wanting to lower taxes and increase infrastructure." But he did feel it necessary to warn that "There is the danger that protectionism will cause global trade to contract and slow global growth."

Recent economic data for Japan have been positive. Industrial production has picked up due to stronger domestic demand and export growth. The production outlook for January and February is for further gains. In December there was a sharp rise in export volume and a continued recovery in export prices due to a weaker yen. Retail sales advanced modestly in December. January's consumer sentiment index reached its strongest level in 40 months. Looking ahead, cash earnings of employees, which have been rising moderately, are expected to accelerate due to a tighter labor market and improving corporate profits. Wage growth should feed into stronger domestic demand.

The Abe government is moving with remarkable speed to strengthen relations with the new US administration. Next week Prime Minister Abe will come to Washington, along with his finance, economic and foreign ministers, for talks with Trump and his cabinet, focusing on trade policy and economic cooperation. A draft proposal for a "US-Japan Growth and Employment Initiative" outlines steps the Japanese government is prepared to take to encourage increased investment and job creation in the US. Abe told members of Japan's House of Representatives, "I wish to discuss (Japanese) contributions toward improved productivity and competitiveness in the entire US industrial sector, or a large framework that includes aid for infrastructure development." Along with the mutual economic benefits of such cooperation, both countries will see the likely geopolitical gains from a strengthened bilateral relationship, particularly vis-à-vis China.

With respect to trade matters, Abe had strongly supported the multilateral Trans-Pacific Partnership negotiations, using his political capital to make some difficult reforms that would have been needed to finalize that agreement. When Trump pulled the US out of the TPP, Abe could have reacted negatively. Instead he has adapted rapidly to the changed situation, shifting his policy direction to the objective of strengthening the bilateral relationship. Trump's accusations that Japan's auto industry is exploiting an "unfair" trade structure and that Japan is manipulating its currency have understandably caused great concern in Japan. We believe that a trade agreement between the US and Japan that reaps some of the bilateral concessions agreed in the TPP negotiations should be attainable if campaign rhetoric is set aside and serious bargaining begins. That will take some time, but the stage could be set in this week's discussions.

We are maintaining our positive view on the Japanese equity market. Over the past six months through February 1, the iShares MSCI Japan ETF (NYSEARCA:EWJ) has gained 7.61% on a total return basis. That compares favorably with the iShares MSCI ACWI ex-U.S. (all countries but the US) ETF (NASDAQ:ACWX), which returned just 5.55%, and also with iShares MSCI EAFE (all advanced economies but North America) ETF (NYSEARCA:EFA), which gained 5.44%. For US dollar-based investors who used a currency-hedged ETF to access the Japan market, the gains were greater due to the yen's fall against the US dollar. For example, the WisdomTree Japan Hedged Equity Fund ETF (NYSEARCA:DXJ) had a six-month total return of 27.67%.

So far this year the dollar has eased somewhat, with the result that while EWJ gained 4.05%, similar to ACWX's 4.25% advance and above EFA's 3.71% return, the hedged DXJ advanced only 1.33%. We expect that over the course of this year the US dollar will continue its trend of strengthening against the Japanese yen as the gap between US and Japanese interest rates widens. We, therefore, continue to prefer using Japanese equity ETFs that are hedged against currency fluctuations for our International and Global Portfolios.