EWJ: Taking Advantage Of The Yen Crash

Summary

• At current levels, the yen is simply too cheap to ignore and should act as a tailwind to returns in the EWJ over the coming years.
• The MSCI Japan, which the EWJ tracks, now trades at a forward PE ratio of 12.8x versus 17.8x for the MSCI World, marking a near-record valuation discount.
• Analysts are clearly anticipating a continued increase in corporate dividend payouts in line with the long-term trend, which has seen dividends grow at 8.5% annually since 2012.
• As a major hydrocarbons importer, the biggest risk comes from continued elevated global oil and gas prices.
• My position in EWJ forms part of a broader portfolio with positive exposure to higher oil prices via the XLE and VDE oil producer ETFs.

KeithBinns/E+ via Getty Images

While Japanese stocks have performed well in local currency terms since my previous article on the iShares MSCI Japan ETF (NYSEARCA:EWJ) in January, the collapse in the yen has resulted in the EWJ being one of the poorest performing developed market ETFs over this period. However, at current levels, the yen is simply too cheap to ignore, and should act as a tailwind to returns over the coming years. If the yen remains at current levels, the country's export sector should receive a huge boost in profitability. As a major hydrocarbons importer, the biggest risk comes from continued elevated global oil and gas prices.

The EWJ ETF

The EWJ tracks the performance of the MSCI Japan index, while excluding the bottom 15% of Japanese companies by market cap, which tilts it slightly larger than the benchmark. Despite seeing huge outflows since its peak in 2018, the EWJ still has a huge AUM of USD10.4bn and an average daily volume of USD452mn, making the ETF highly liquid. The ETF is also among the most diversified major equity markets, with the largest stock, Toyota (TM), making up just 5.3% of the index and the top 10 stocks making up just 23%. The biggest drawback is the 0.51% expense ratio, which is particularly high relative to the dividend yield of 2.2%.

EWJ Vs DXY ETF Performance (Bloomberg)

The EWJ has dramatically underperformed the WisdomTree Japan Hedged Equity ETF (DXJ) as the latter is currency hedged meaning that returns have not been undermined by the fall in the Japanese currency. However, going forward, the yen should be expected to be a strong positive contributor to Japanese equity returns given its truly extreme level of undervaluation. For investors looking for international exposure, reasonable valuations, and the prospect of dividend growth, the EWJ is a solid bet.

Looking Beyond The Yen's Short-Term Headwinds

Rising interest rate expectations in the U.S. and indeed most of the rest of the world have kicked the legs from under the yen, as the Bank of Japan (BoJ) has remained committed to pinning down long-term bond yields. While the BoJ has explicitly stated that its insistence on keeping interest rates near zero is solely a factor of monetary policy, the truth is that the country's extreme government debt load makes higher interest costs unpalatable for Japanese policymakers, who have therefore decided to sacrifice the stability of the yen instead.

While further upside pressure on U.S. interest rates would likely result in further yen weakness as yield differentials between the two countries diverge further, the significantly lower level of inflation expectations in Japan mean that real bond yields remain on par with the U.S. as the chart below shows. This suggests that the yen's weakness has been a major overreaction and would only be justified if we saw much further increases in U.S. yields or a long-overdue rise in Japanese inflation expectations.

10-Year Inflation-Linked Bond Yields, U.S. Vs Japan (Bloomberg)

Even if this were to occur, it would be unlikely to prevent long-term yen appreciation. The reason being that while currencies move in response to interest rates in the near term, over the longer term, they respond to global competitiveness. On this metric, the yen is now more undervalued than it was in the early 1980s, trading 38% below its fair value based on average price levels in the two countries. This puts the fair value of the yen at just JPY76/USD. Over the long term, we should expect to see the yen's extreme level of undervaluation manifest in greater external competitiveness which should allow the currency to appreciate.

USDJPY Vs Fair Value Based On PPP (Bloomberg, World Bank)

Japanese Stocks Are Relatively Undervalued

The weakness in the yen has benefitted Japanese stocks in local currency terms as a large share of corporate revenues are generated from exports. The chart below shows how the MSCI Japan has performed in line with the MSCI World over the past 6 months, while the EWJ has underperformed due to the weaker yen.

MSCI Japan (In JPY), MSCI World, And EWJ ETF (Bloomberg)

In terms of valuations, however, the weaker yen has left Japanese stocks even more undervalued relative to developed markets on a forward-looking basis thanks to a sharp rise in earnings expectations. The MSCI Japan now trades at a forward PE ratio of 12.8x versus 17.8x for the MSCI World, marking a near-record valuation discount.

Forward PE Ratios: MSCI Japan Vs MSCI World (Bloomberg)

Dividend Growth Continues To Outstrip The World

The strong outlook for dividend growth arguably makes Japanese stocks even more attractive relative to the MSCI World. The MSCI Japan's forward dividend yield is now a record 32% higher than the MSCI World, at 2.6% vs 1.9% according to Bloomberg analyst estimates. Analysts are clearly anticipating a continued increase in corporate dividend payouts in line with the long-term trend.

Forward Dividend Yield: MSCI Japan Vs MSCI World (Bloomberg)

In part, this higher dividend yield is due to the increase in expected earnings, supported in part by the yen's recent weakness. However, as I argued in my previous article, it also reflects structural improvements in corporate governance in the country. Since corporate governance reforms began under former Prime Minister Shinzo Abe in 2012, dividends per share on the MSCI Japan have risen at an annual pace of 8.5%, outperforming every other developed market, including the U.S. Since 2020, this has been aided by surge in share buybacks, which have seen the net share count fall by 8%, halting the long-term rise in the index' share count.

Dividend Growth Rebased To 2012: MSCI Japan Vs MSCI World (Bloomberg)

Sustained Energy Prices Are The Main Risk

Japan imports almost 90% of its energy needs and does not appear to have a coherent policy to reduce this figure any time soon, so the spike in global energy prices is a clear and present headwind to the economy and corporate profits. We have seen this manifest in a surge in producer price inflation in recent months and a widening of the trade deficit. A look at the country's terms of trade index also suggests that things are likely to get worse before they get better.

Japan Trade Balance Vs Terms Of Trade (Bloomberg, Goldman Sachs, MoF)

It should be noted that while Japan's reliance on energy in terms of its percentage imports is extremely high, total imports accounted for less than 2% of GDP in 2021, far lower than many other net oil importers due to its more efficient use and huge domestic economy. Nonetheless, continued high oil prices would certainly cut into the otherwise strong earnings outlook for the EWJ, which should be a key consideration for investors. Personally, my position in EWJ forms part of a broader portfolio with positive exposure to higher oil prices via the XLE and VDE oil producer ETFs.

Analyst’s Disclosure: I/we have a beneficial long position in the shares of EWJ, DFJ either through stock ownership, options, or other derivatives. 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.