Japan's Tremors: Market Top Or Entry Point?

This year foreign investors have plowed almost $80 billion into Japanese equities, which have been leading global markets. By Wednesday, May 22, the market was up 46% year-to-date. Suddenly late last week the Japan market tumbled, with the Nikkei falling 7% on Thursday, May 23. This was the largest one-day plunge since March 2011, the time of the earthquake, tsunami and Fukushima nuclear meltdown. Some additional, more modest, easing occurred on Friday, followed by a further 3% drop Monday. Today, Tuesday, May 28, the Nikkei recovered by 1.2% as global markets rise. Do these moves signal a top for Japanese equities, or is this a welcome short-term correction in a market that has gotten a bit ahead of itself? Is this pullback an entry point to a market that promises further outperformance?

Why The Retreat?
There are several reasons the market pullback occurred when it did. Global equity markets were in retreat because of softer than expected economic data out of China and concerns that the US Federal Reserve might start tapering off its bond purchases (quantitative easing) sooner than expected. We don’t share the latter concern but do agree that any weakness in the Chinese economy would have global implications. It was not surprising to see Japanese equities retreat along with other major markets. But we need to look further to understand the extent of Japan’s market decline.

The most likely contributing factor was the extreme volatility in the Japanese government bond market, where 10-year yields surged to almost 1% before retreating back to 0.85%. The bond market was evidently confused about the Bank of Japan’s policy and the communications of BoJ’s new Governor, Haruhiko Kuroda. The stated policy is to keep interest rates very low through massive purchases of bonds to encourage investors to move out of Japanese government bonds and into Japanese equities and foreign assets, to increase inflation expectations, and to revive the economy. Kuroda confused market participants by acknowledging that, to the extent the policy succeeds in reviving the economy, interest rates will tend to rise. This was viewed as being contradictory with the low-interest-rate policy, and yields spiked. It is not, however, a contradiction if one takes into account the time factor. Low rates now encourage growth, which eventually will have the effect of raising rates. The BoJ will be seeking to stabilize the bond market by flexibly adjusting its bond purchasing program and fine-tuning its communications skills.

Conflicting Goals?
No doubt instability in the government bond markets and confusing communications by the BoJ have worked to undermine equity investor confidence. The communications difficulty faced by Kuroda was underlined by news today that, in the latest meeting of the BoJ, “a few” board members said that swings in financial markets are due to perceptions that the BoJ has conflicting goals. Moreover, they questioned the feasibility of reaching the 2% inflation goal.

Our Take
The equity market correction may well continue a bit further, but we believe the upward trend in Japanese equities will resume as the massive policy stimulation takes hold. Note that one element of the Bank of Japan’s stated policy is to double its direct investment in the total Japan market ETF, MSCI Japan (EWJ), to 3.5 trillion yen ($35.2 billion). Stimulating the equity market is a clear policy objective. Accordingly, the pullback represents an entry point to participate in a market that may outperform, not only in the coming months, but possibly well into 2014. Following more than two decades of underperformance, there remains ample room for a further recovery in this market if, as seems likely, “Abenomics” is successful in promoting growth in the Japanese economy.

In our next Japan note we will discuss prospects for the yen and why we continue to prefer Wisdom Tree’s currency-hedged Japan equity ETF, DXJ.

This commentary was written by Bill Witherell, Cumberland’s Chief Global Economist. He joined Cumberland after years of experience at the OECD in Paris. His bio is found on Cumberland’s home page, www.cumber.com. He can be reached at Bill.Witherell@cumber.com.