By Bill Witherell
The recovery of the global economy has continued thus far in 2017, and stock markets have generally registered healthy advances. In the US, the SPDR S&P 500 ETF, SPY, gained 5.62 year-to-date April 11 on a total return basis; the iShares MSCI ACWI ex-U.S. Index ETF, ACWX, gained 8.12%; and in Asia the iShares MSCI All Country Asia ex-Japan Index ETF, AAXJ, rose a strong 13.85%. In contrast, in Japan the TOPIX dropped 2.57%, and the Nikkei 225 lost 2.94%. These results for the Japanese market are the local-currency returns. The iShares MSCI Japan ETF, EWJ, gained 4.81% year-to-date for US dollar investors. This return, while underperforming the broader indexes cited above, is still presentable. But when compared with the year-to-date return of the iShares Currency Hedged MSCI Japan ETF, HEWJ, which sustained a loss of 1.22%, it is evident that all of the gain in EWJ was due to appreciation of the yen.
This weakness in Japanese equities is very recent. Japanese stocks peaked on March 13 and have trended downward since. The Nikkei 225 lost 4.10% over the past month, and the TOPIX is off 6.00%. However, the longer-term trend is strongly positive. For example, the one-year return for the Nikkei 225 is 16.47%. The critical question is, then, will the current weakness in Japanese equities continue, or is a return to the longer-term upward trend more likely?
One factor behind the decline in Japanese equities was probably the general weakness in US stocks since the beginning of March. Yet over the past month up to April 11, the decline in SPY was just 0.73%. We have to look further for the causes. The macroeconomic situation in Japan may have played a role, as it is mixed. The Nikkei Japan Composite Output measure for March reached a 19-month high, with strengthened service-sector activity more than offsetting somewhat slower growth in manufacturing output.
Overall confidence in Japanese manufacturing going forward, however, is the lowest in four months as a result of concerns about overseas competition. Yen depreciation in the second half of 2016 has supported new export orders, with the volume of goods exports rising 7.4% in the January-February period compared with a year ago. But the upward trend in the yen this year - it has appreciated almost 6% year-to-date versus the US dollar - has likely dampened trade expectations. The March Bank of Japan Tankan Survey indicated a broad improvement in business conditions, with strengthened capital expenditure intentions. Yet, looking three months ahead, business sentiment is worsening. On the positive side, consumer sentiment strengthened in March.
On balance, we expect Japanese economic growth as measured by GDP to advance by 1.5% this year, compared with last year's 1.0% growth and estimated long-term potential growth of just 0.7%. Both monetary and fiscal policies will be supportive of the economy. This level of economic performance, together with continued Bank of Japan purchases of Japanese ETFs (with the stated objective of reducing the risk premium in the equity market), should be bullish for that market.
We see three risks to this positive outlook. First, there lingers a political scandal involving Prime Minister Abe and his wife and possible preferential treatment of a private school. That could pose a political threat to the Abe government and hence to his policies. Second, the current strong growth of the Chinese economy, which accounts for almost 20% of Japan's exports, could slow significantly if China's efforts to moderate credit growth become too restrictive. The third risk - the greatest risk in our view and the likely reason for the current worsening business and equity market sentiment - is that the yen will continue to strengthen rather than return to last autumn's depreciating trend. A stronger yen would have important negative effects on Japan's exports, overall economy, and investor sentiment.
Forecasting the exchange rate of the yen is difficult because of its role as a haven currency in times of heightened risk, particularly geopolitical risk in the Asia-Pacific region. The Japanese government and the Bank of Japan clearly would like to see the yen reverse its current strengthening. The Bank of Japan is expected to continue its present highly accommodative "Yield Curve Control" (YCC0) monetary policy this year, keeping the 10-year government bond (JGB) yield close to 0.0%. In the US, the Federal Reserve will likely increase interest rates two or three more times this year. A widening interest-rate differential between the US and Japan would be expected to lead to a strengthening of the US dollar versus the yen. Also, the US economy is expected to have stronger growth than the Japanese economy. However, these factors could well be more than offset by further increases in perceived geopolitical risks. Current developments with respect to North Korea, the South China Sea, Russia, the upcoming elections in Europe, and Brexit negotiations, along with the continuing uncertainty about the future direction of US policies, suggest that the likelihood of heightened political risk in the coming months is great. Such a development would likely be positive for the yen and negative for Japanese stocks.