Though my recent interview with Rhonda Schaffler begins with a discussion of the case for natural gas, it closes with an easy summary of the basic argument for Japan, and it is the case for Japan that I'd like to explore in this commentary. (http://www.thestreet.com/story/13450074/1/natural-gas-stocks-are-falling-here-rsquo-s-why-one-investor-is-buying.html)
The transcript of a recent speech on Bank of Japan (BOJ) policy by BOJ Governor Kuroda is available here:http://www.boj.or.jp/en/announcements/press/koen_2016/data/ko160203a1.pdf.
We have written on Japan, and those commentaries are available atwww.cumber.com. Today let's delve into our Japan investment rationale. Cumberland's international ETF strategy (non-US) currently has a 30% weight in the Japanese stock market. That is our highest overweight ever. The index benchmark weight is 17%. Roughly two-thirds of our ETF positions are currency-hedged.
Why the high overweight?
The first consideration is valuation. The Japanese ETF carries a list of excellent companies. These companies presently hold large cash hoards, and they are profitable. Based on the monetary outlook for Japan (zero or lower interest rates on riskless government debt), the equity risk premium is about 650 basis points. Furthermore, we see the BOJ's policy of zero or lower interest rates remaining in place for the rest of the decade. Those factors translate into an earnings yield of between 6% and 7% in the current environment (source: Bloomberg).
A 600 to 700 basis-point earnings yield from a mature G7 economy is a special gift to investors in the present global asset management environment. Add to that yield currency protection for US investors and also add the likelihood that the riskless yield will remain zero for years, and the equity risk premium for Japanese stocks suggests they will probably double in value in US-dollar terms. Now, we admit that a forecast of a double is an extreme one. And we do not know that it will be realized. But we do know that an equity risk premium this high is a very rare bargain.
Let's now make a case for economic growth in Japan.
BOJ Governor Kuroda has committed to keeping his combination of NIRP and ZIRP in place until Japan has clearly surpassed an inflation target of 2%. Japan hasn't achieved that level in two decades. Their demographics and the closed nature of their economy have prevented them from doing so. For many years, inflation expectations in Japan have been disappointed, but now there has been a major policy change.
The Abe regime is moving the country away from a passive defense posture dependent on the United States to a more active one. They have good reason to do that, as one can see from the latest North Korean missile launch. For full discussion of the North Korean threat to Japan, as seen from the Japanese perspective, we recommend the various articles in the Japan Times. Seehttp://www.japantimes.co.jp/tag/north-korea.
Japan is observing and resisting Chinese incursions into the disputed islands of the South China Sea. For a discussion of the history of this ancient enmity between Japan and China, see this article by the Council of Foreign Relations:http://www.cfr.org/asia-and-pacific/chinas-maritime-disputes/p31345 - !/.
Abe has already obtained legislative support for this controversial policy shift. He is now proceeding with an attempt to revise Article 9 of his country's constitution, which has not been altered since 1946. Thus the remilitarization of Japan is underway and accelerating. For a deep discussion see "A chronology of Japan's Remilitarization" by Stratfor, July 15, 2015:www.stratfor.com/analysis/chronology-japans-remilitarization.
Of course, we are not sanguine about rising military pressures. And we have our views about the United States and its limitations when it comes to military policy. But we understand Japan's felt need to rearm and boost defense.
So what is our investment thesis, besides a long-term zero interest-rate policy and a compelling valuation? The additional piece is growth. History shows that countries grow when they ramp up military expenditures. Economic activity increases. In Japan's case this additional activity will be of a very high technological type.
There are straightforward reasons for this forecast. Japan faces a growing shortage of younger men and women who might serve in the defense forces. Unlike North Korea or China, where there are many young people available to don uniforms, Japan has to take a different tactical route: It must utilize the most advanced forms of military technology in lieu of large numbers of people. In the case of Japan, that capability exists. Japan has a long history of taking any technology from anywhere in the world and improving upon it. We expect Japanese defense expenditures to ramp up in the military technological space.
That push means rapid growth in Japan's all-important manufacturing sector, and it also means that lots of civilian applications will originate from the military effort. (History teaches us that military technology readily translates to civilian commercial applications.) Japan has the skill and depth to become a formidable military force in the world.
What about financing? Here is where the rubber hits the road in Japan and the economy really gets some traction. Imagine the capacity to expand the government's deficit with nearly unlimited defense expenditures and to do so at an interest rate of 0%. There is no current cost so expanding the budget in order to defend the country becomes easy. Down the road there may be a price to pay in inflation, but that is a long time away. Meanwhile, the expenditures positively impact Japanese businesses. And those are businesses that are currently trading at about half the traditional equity risk premium.
In short, Japan's growth rate is about to pick up as significant defense expenditures are added to the current fiscal mix. The financing is in place at zero interest rates in order to do make those expenditures possible. The stocks of the companies that will be affected are really cheap by any traditional valuation. And the BOJ's policy mechanics are in place and fully transparent.
We are bullish on Japan. We think it is setting up as a major strategic investment position. We expect volatility and headline risk to rise with each subsequent Asian geopolitical event, as they have with last week's North Korean missile launch. Volatility and headline risk provide entry points to investors who do their homework and then stake out positions without emotional attachment.
Do we like this notion of profiteering because of war or the risk of war? No. Do we like the situation we see unfolding in the South China Sea? No. We have studied the history of the region, and it is a source of concern. Many may have forgotten that Japan attacked Hong Kong along with Hawaii on December 7, 1941. Our American-centric history lessons focus rightly on Pearl Harbor, but those lessons have denied our students the full scope of the history involved.
A personal note: I have toured and walked portions of the route into Hong Kong taken by Japan at the onset of World War II. And I have toured Pearl Harbor. My father served in the US Navy during World War II and was stationed in the Pacific. I do not like war.
That said, the job of an investment professional is to ferret out an investment strategy and research it deeply. Once enough evidence is in place, the job of the professional is to then deploy investment assets and seize opportunities. Japan now presents such an opportunity. We are deployed. We have followed the Asian event build-up closely and continue to do so. If things change, we will change. But right now we are acting on the bullish case for Japan.