For some time, one of our stronger themes has been to buy Japanese stocks with the yen hedged. An update on this topic seems warranted at this time. Measured to mid-October of this year, a fairly large range of returns can be calculated between the Nikkei and the ACWI. Depending on the date used to calculate returns, outperformance by the Nikkei can be seen as high as 8% and a similar number can be seen if looking for underperformance by just changing the start date. A currency-hedged ETF such as DXJ or DBJP has increased the upside and decreased the downside when looking at similar measurement periods. As always, different stories can be written depending on when return calculations start. What really matters is the outlook going forward. We believe that improving earnings, valuations, monetary policy, and reforms all point to a strong relative value story tipping in favor of Japan.
Japan has seen one of the strongest EPS trends of any country in the ACWI. While they have slowed recently, the longer-term growth rate remains around 10%. Valuations are attractive on an absolute and relative basis. Out of a universe of 40 countries, Japan has the 7th lowest price to book ratio (1.35x) and the 9th lowest price to cash earnings ratio (7.88x). Relative to history, Japan has the #1 ranked value profile. Japan’s current P/E ratio is 6.18x lower than its 5 year average P/E ratio. Lastly, Japan’s forward P/E multiple is trading at a 10.6% discount to the MSCI World, the largest discount in 20 years.Monetary policy has become one of the most important drivers of stock market outlook. While the market has not necessarily rewarded countries with cheap valuations or countries with relatively strong fundamentals, it has rewarded countries where the central bank is loose. The playbook since the crisis has been to buy stocks on pullbacks in the market where monetary policy is most accommodating. That has meant the US for some time has been the stock market to buy on pullbacks. With the Fed at a key juncture in its policy, meaning moving to neutral, the Bank of Japan is the central bank that wears the mantle of most accommodating.
Recent economic data has come in weaker than expected in Japan, but this will lead to further easing of monetary policy within weeks perhaps. This is the stated policy of the Abe regime which is actively devaluing the yen in pursuit of inflation. The BoJ is entrenched in policies that will depreciate the currency in order to gain a competitive edge internationally. This makes companies more profitable; that seems to be a clear outcome. Whether the BoJ can engineer an economy that grows consistently at an acceptable rate and breaks a multi-decade deflationary cycle is a question with a less-clear answer. As equity investors, owning export-oriented companies and hedging that exposure out of JPY into USD is an attractive play. The average forecast of 80 financial institutions is for JPY to move to 115 over the next year. Against EUR, the yen is expected to weaken as well. For the Japanese economy to recover, a depreciation of the yen is a necessary condition. While the Fed approaches the end of QE, the BoJ will be expanding its balance sheet, gaining a relative monetary policy advantage.
On the reform side of the ledger, expectations for more aggressive action should be expected on several fronts; tax, labor, social spending, electoral system, agriculture, immigration, and education. What should also be of interest to equity investors is the announcement that the Government Pension Investment Fund is planning to increase its allocation of domestic equities to 25%. The current allocation is 12%. The increase could drive purchases of up to ¥8T of Japanese equities. Other mutual funds that follow the GPIF weights could create buying demand double that amount. It is also probable that Abe delays the raising of the consumption tax that affected the market negatively in the spring.
Based on fundamentals and valuations, our call is to have an overweight to Japanese stocks in core strategies. A weaker yen is part of that outlook as we believe many of the companies in the index will do well given a more competitive stance with a weaker currency. Typically we would add to the analysis that a potential currency appreciation creates additional return possibilities. In the case of Japan, we do not expect currency appreciation to play out, hence our desire to hedge the yen when it comes to owning Japanese stocks. While there are other ways to do this, an ETF is our preferred vehicle. The ease of purchase, the very low cost relative to replicating the strategy independently, intra-day liquidity, and instant diversification all play into the selection. DBJP and DXJ both fit the bill. We have rotated between the two based on our view of relative value at the sector levels where there are key differences between these two ETFs.
Disclosures: This article was compiled by Brad Jensen, a Portfolio Manager at Accuvest Global Advisors. This article is strictly informational and should be used for research use only. It should not be construed as advertising material. The opinions expressed are not intended to provide investing or other advice or guidance with respect to the matters addressed in this brochure. All relevant facts, including individual circumstances, need to be considered by the reader to arrive at investment conclusions to comply with matters addressed in this brochure. Charts and information are sourced from Bloomberg, unless otherwise noted. Remember that investing involves risks, as the value of your investment will fluctuate over time and you may gain or lose money. You should seek advice from your financial adviser before making investment decisions. Investment risks are borne solely by the investor and not by AGA. AGA is an independent investment advisor registered with the SEC. All disclosures, marketing brochures, and supplemental firm sheets are available upon request.