Consider first the macroeconomic story. The Japanese economic recovery continues. Growth in the first quarter at an annual rate of 2.4% was the fastest among the large developed economies, with consumption, investment, and inventory build-up all contributing to the advance. Growth slowed somewhat in the second quarter but maintained momentum despite the slowdown in China. Some press commentaries have overstated the impact of China. That market accounts for 18.1% of Japan’s exports, compared to 18.8% for the United States and 10% for the European Union, markets that are not slowing. Indeed, a global economic reacceleration appears to be underway, while the slowdown in China looks more modest than many projected. Moreover, the lower exchange rate of the yen against other major currencies has improved Japan’s competitiveness and boosted exports.
The most recent Tankan survey of investment intentions is the strongest since 2006. More generally, the survey shows optimism in both the manufacturing and non-manufacturing sectors. Labor demand is strong. Consumption continues to recover after the drop last year due to the consumption tax increase. Overall the growth outlook looks positive well into 2016.
The massive quantitative easing program in which the Bank of Japan (BOJ) is engaged will continue indefinitely. Inflation is still close to zero, while inflation expectations are rather higher, with the majority anticipating inflation above 2% one year from now. The steep increase in inflation expectations must be encouraging to the BOJ. An increase in the QE program, now at the level of 80 trillion yen annually, still looks likely – but not perhaps until 2016. So far the effect of the program on broad money growth has been modest, as has been the effect on GDP growth through that channel. A greater boost has come from the program’s effects on the exchange rate and exports (positive) and imports (negative).
Another effect of the BOJ’s massive buying of Japan government bonds (JGBs) is important for the equity market. The BOJ now owns about 25% of the outstanding stock of JGBs, leading to significant portfolio reallocations on the part of financial institutions. This trend is particularly noticeable in the case of public pensions that are selling JGBs to the BOJ and buying equities. And not to be forgotten is the fact that the asset-buying program of the BOJ includes significant purchases of Japanese equity ETFs.
The earnings outlook for Japanese firms is encouraging. Consensus profit growth for the second quarter is 22.7% over the previous quarter, with a reacceleration of both revenue and earnings. Along with the favorable macroeconomic conditions, there is a new interest in corporate reforms in Japan that should begin to have a positive effect on shareholder returns through increased profits and cash returned to shareholders via dividends and share buybacks. Corporate balance sheets now contain very large amounts of cash.
Barron’s reports that Japanese company profits are already growing much faster, from a smaller basis, than those of US firms. There is great scope for Japanese firms to improve their profitability; and pressures from government, shareholders, and competitors have increased substantially. Japan has introduced a new corporate governance code, which has the objective of strengthening shareholder rights. Pressure to increase dividend payouts led to a 58% increase in the number of firms raising their dividends last year, actions that appear to have been rewarded by the market.
Valuations in Japan remain attractive despite the equity price increases of the past two years. Price-to-book and price-to-equity ratios are still below their long-term averages and the broad averages of the rest of the world.
There are now some 29 Japan equity ETFs available on the US market. The largest, with more than $20 billion market capitalization and thus market-leading liquidity, is the iShares MSCI Japan (NYSE:EWJ). Its year-to-date (July 23) performance is 15.08%. The version of this ETF that is hedged against currency movements is the iShares Currency Hedged MSCI Germany (NYSE:HEWG). Its year-to-date performance is 18.49%, with the better performance attributable to removing the effect of the yen’s depreciation. We hold in our International and Global ETF Portfolios the WisdomTree Japan Hedged Equity (NYSE:DXJ). While its year-to-date performance of 16.91% is less than for HEWJ, we continue to think that, going forward, the dividend-weighting approach of this ETF will benefit from the market, rewarding firms with higher dividend payouts.
We are also looking with interest at an ETF launched just last month, the Deutsch X-Trackers Japan JPX-Nikkei 400 Equity ETF, JPN. This ETF tracks the JPX-Nikkei 400 Total Return Index. This index screens companies based on their “quality” as reflected by consistent earnings, high return on equity, and rigorous corporate governance standards. We are monitoring whether investors will be attracted to this quality selection process.