Bank Of Japan Surprises with Aggressive Easing

Despite extensive advance signals, the Bank of Japan (BOJ) managed to surprise global markets Thursday, April 4th, with the magnitude and extent of the policy moves it announced. Many market analysts had been expecting that the BOJ would disappoint when it held its first meeting under its new leadership. Instead Governor Haruhiko Kuroda announced that the BOJ is pulling out all the stops in the effort to stimulate the world’s third-largest economy (after the US and China), following two decades of stagnation. The immediate effect on markets has been significant. The yen, which had been strengthening recently, plunged, with the US dollar rising almost 3% against the yen after the announcement.

Foremost among its policy moves, the BOJ intends to double the size of Japan’s monetary base from 135 trillion yen to 270 trillion yen by March 2015. The pace of quantitative easing is stunning, as the balance sheet of the BOJ will expand by 1% of the nation’s gross domestic product (GDP) each month in 2013 and 1.1% in 2014. This is almost twice the current pace of 0.54% of GDP engaged in by the US Federal Reserve. The BOJ will accomplish this by doubling its purchases of government bonds. In contrast to the BOJ’s previous asset purchase program’s focus on short-term bonds, the new program will include longer-dated bonds out to 40-year debt, raising the average maturity from about three to seven years. The total amount to be purchased by the BOJ in 2013 and 2014 will be some 30% larger than the IMF’s estimated net increase in Japan’s government debt, implying that other holders of Japan’s debt are expected to sell some of their holdings. There likely will be downward pressure on rates throughout the yield curve. The BOJ will also be making more purchases of risk assets, including one trillion yen of ETFs and 30 billion yen of REITs, which will affect positively their respective Japanese markets.

The BOJ also formally targeted reaching an inflation rate of 2% within two years. This objective looks very difficult to achieve in view of the persistent deflation that has gripped the economy. In view of the current spare capacity in the Japanese economy, the stimulus to private spending will have to be very substantial in order to generate general inflationary pressures that rapidly. However, the effects on financial asset prices will be rapid and significant.

Japan’s equity market has been advancing since late last year, as the election of the Abe government promised increased stimulus to the economy, particularly from the BOJ under new leadership. The Nikkei 225 Index is up 21.54% year-to-date as of April 3rd – that is, before the BOJ announcement . We expect this equity rally to continue in view of the BOJ’s new policies. Our International and Global Multi-Asset Class ETF Portfolios currently hold overweight positions in Japanese equities: 20% versus the ACWX benchmark’s 13.5% weight in the International Portfolio and 13% versus the ACWI benchmark’s 7.24% weight in the Global Multi-Asset Class Portfolio.

We are using the Wisdom Tree Japan Hedged Equity Fund ETF, DXJ, to provide exposure to Japanese equity securities while avoiding the negative effect on US dollar returns from the yen’s depreciation. This ETF includes a hedge designed to provide the local-market Japan equity return without the effect of fluctuations in the exchange rate between the US dollar and the Japanese yen. The fund enters into one-month forward contracts each month and rebalances at month-end. The fund also weights companies by their dividend streams and focuses on the largest dividend-paying companies which have no more than 80% of their revenue generated from inside Japan. At the time of writing DXJ is up 7.50% following the BOJ announcement. In comparison, the widely held iShares Japan Index Fund ETF, EWJ, which is not hedged, is up 4.11%. The difference between the two is largely due to the fall in the yen. We are anticipating further yen weakness in the coming months.

BY Bill Witherell