Investing in Japan - the good, the bad and the ugly

Japan has embarked upon a bold new experiment to boost its moribund economy using monetary, fiscal and structural measures – the “three arrows” – and investors too will need to make sure their aim is steady and straight if they are to hit the mark, as Dominic McCormick reports.

Japan has been a major focus lately, as it first flagged and then implemented its new “shock and awe” monetary policy in early April involving the Bank of Japan buying 60-70 trillion yen worth of Japanese bonds each month, aiming to double the monetary base in two years, as well as generate 2 per cent inflation.

This has sparked a major sharemarket rally with the Nikkei Index leading major global stockmarkets, up 51 per cent over the 2012/2013 financial year.      

But the Japan story is not just about equities and it is difficult to have a view on the equities outlook or the economy without having an opinion on the outlook for two other Japanese financial variables – Japanese Government Bonds (JGBs) and the yen.  

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In terms of fundamentals and future direction of these three key financial variables, one could characterise them as the good (equities), the bad (currency) and the ugly (JGBs). Although, as with the three characters in the movie of the same name, this categorisation is far from clear cut.  

Let’s look at each of these key variables in turn.    

The good – Japanese equities  

Clearly, Japanese equities have responded well so far to much more aggressive monetary policy, a resulting weaker currency and a broader commitment to resurrect the Japanese economy.

But Japanese equities are also benefiting from a rebound from decades of neglect that had resulted in valuations below many markets. 

Even following recent outperformance, Japan still trades at a price-to-book ratio around 1.5, still considerably below most other major markets (US is around 2.4, while Australia is just under 2.0). 

Trailing Price Earnings ratios currently seem relatively high but partly reflect conservative accounting and the low return of equity, which is expected to be partly remedied by a lower yen, structural reforms and more shareholder-friendly management.   

It is worth highlighting that performance of the Nikkei noted above is in local currency terms. Investors in currencies outside the yen have not achieved these returns unless they have fully hedged the currency.

This is even the case for Australian investors, where the local dollar has recently been weak. 

For example, in the year to 30 June 2013, an investment in the local listed iShares Japan ETF returned 33.5 per cent. But if you had hedged the currency, the return would have been 49.6 per cent.

Some managers who have been active in both stock selection and currency have returned even more. 

Clearly, the changes in Japan have created good opportunities for stock-pickers in the last year or so. Could Japanese equities continue to perform?

The bullish case is that valuations are still relatively inexpensive and Japan is one of the few economies in the world that is actively engaged in stimulating its economy through monetary, fiscal and structural measures (the so-called “three arrows”).

No other developed economy in the world is doing this.  

On the other hand, there remain considerable risks. Efforts to stimulate the economy may fail or confidence may be undermined by disorderly moves in the currency or bond market (more below). In any case, it will likely be a volatile ride - as the recent 20 per cent equity correction in late May/early June highlighted. 

The bad – the Japanese yen  

Bank of Japan governor Kuroda has said that Japan is not specifically targeting a weaker currency.

However, the effect of trying to double the monetary base in two years is quite clear, and a weaker currency is necessary for the policy to work. Given this, it is likely yen weakness will continue.  

Having said this, against the Australian dollar, the yen hasn’t fallen as much given the recent local weakness against major currencies.   

A big risk is that the yen fall turns into a disorderly decline, which causes a rush out of Japanese assets and feeds into a downward spiral.      

To the extent that investors have Japanese equity exposure, further significant weakness in the yen could continue to weigh on returns, even for Australian investors betting on further falls in the AUD/USD exchange rate.

A fully, partially or actively hedged currency approach therefore makes sense for any specific exposure to Japan.      

The ugly – Japanese bonds  

Ten-year Japanese Government Bonds (JGBs) hit a record low of 0.315 per cent in early April, as news of the implementation of new monetary stimulus program was first announced.

There have been elevated levels of volatility since, with yields rising above 1 per cent at one point and currently just under that level.   

However, even current yields still are very low in long-term historical terms. Indeed, under the current policy it is hard to see 10-year Japanese bonds at sub-1 per cent being anything but an ugly investment over the next few years. There are two scenarios:  

Either the Government is successful in achieving its 2 per cent inflation target, in which case a negative real return of more than minus 1 per cent is best case, with significant capital losses possible if bond yields eventually adjust upwards to 3-4 per cent to provide a reasonable real return or, 

The policies fail to get the economy going - as a result, the Japanese debt problem gets worse and eventually Japan defaults, or an ugly hyperinflation event occurs as central bank printing press accelerates. In this case JGB investors could be destroyed.

The key problem is that any significant rise in rates makes it difficult to finance the continuing large deficit given, the starting point of government debt is running at 245 per cent of GDP or 20 times government revenue. 

The market is running out of rational JGB buyers – and existing holders have increasing reasons to sell. For example, demographic pressures will mean some large pension fund holders will have to sell as retirees draw down their capital to finance retirement.          

Kyle Bass of Dallas-based hedge fund Hayman Capital holds a view that sales of Japanese bonds by Japanese institutions will mean that the current size of their quantitative easing program will be inadequate, and that they may need to double it to prevent bond yields spiking higher. 

Either way bonds do not seem a pretty place to be, despite the reputation for the short Japanese bond trade being a widow-maker.  

Investing in Japan

Clearly there is little case for investing in Japanese bonds, given current low yields and the risks detailed above.  

The currency’s short-term direction is less clear, but given the need for the economy to receive the benefits of a weaker yen and the possibility of even more aggressive monetary policy, it seems likely to fall further against the US dollar and other currencies in the medium term. 

Its fate against the AUD is probably less clear if yen weakness remains orderly and China’s slowing continues to weigh on the AUD.

Therefore, to the extent one is investing in the Japanese share market, it continues to make sense to adopt a hedged or active currency approach.    

But should investors even be making a specific allocation to Japanese equities? One approach is simply to leave the Japan decision to global managers or invest in a broad global index passively. 

However, in a benchmark-focused world where Japan’s share in most global equity benchmarks was as low as 5 per cent in recent years (currently around 8-9 per cent), one may be getting minimal look-through exposure in a diversified portfolio.

This is particularly the case as some global equity managers continue to have no exposure to Japan – although a minority have it as a significant overweight.  

Therefore, if investors want to ensure a reasonable, specific exposure to Japanese equities, this may require an explicit allocation to a Japanese equity fund or ETF.

However, even if one accepts a bullish case for equities, investors need to recognise the implications and risks of a weak currency or an ugly bond market blow-up.  

Kyle Bass of Hayman sees no easy way out for Japan and has structured a series of specialist funds seeking to benefit from a significantly weaker Japanese yen and/or higher Japanese bond yields (and is also negative on their equity market).

These funds have already returned as much as 200 per cent in the last financial year, as the yen has weakened and JGB market volatility exploded.   

Our own approach has been to hold a core position in an active Japanese equity fund where the currency exposure is also actively managed.

We have also used the Japanese ETFs to adjust the level of exposure from an asset allocation perspective over time, while explicitly hedging the currency on this exposure. 

In some portfolios, we have made small allocations to the short yen/short JGB thematic macro funds offered by Hayman Capital.   

Finding attractive contrarian investment ideas in the current market is difficult. After more than a 20-year bear market and with the Nikkei still 60 per cent below its 1989 high, Japanese equities arguably still constitute an attractive contrarian investment, despite the rally in the last 12 months. 

Japan’s equities are arguably still cheap, particularly if businesses are run more efficiently and the currency headwinds continue to ease.

Equities may benefit from the three sources of stimulus and have for years been under-owned by locals and foreigners alike. Local Japanese investors are being forced into the local sharemarket by lack of opportunities elsewhere.   

Bonds on the other hand are over-owned by local investors and institutions – and their fundamentals will deteriorate if the stimulus is successful.

These dynamics suggest that recent trends of higher equities, a lower currency and higher bond yields can continue – although none will occur in a straight line, and high volatility in all three variables should be expected.   

Conclusion 

Japan clearly currently faces extraordinary challenges. With the economy having struggled for two decades, something had to change, but the policy path they have taken is hugely experimental and may fail.

The risks for the economy and investors are significant, with a disorderly decline in the currency and/or an excessive spike in bonds most prominent.  

Investors allocating specifically to Japanese equities need to be aware of, and consider ways, to manage these risks. 

Dominic McCormick is the chief investment officer and chief financial officer of Select Asset Management.