Japanese Elections: The Bull Market For Equities Will Likely Continue

Japanese Prime Minister Shinzo Abe received a vote of confidence for his growth and reform agenda Sunday as his Liberal Democratic Party and its small coalition partner won a landslide victory in the elections for the Diet's (Parliament's) upper house. Having won majority control of the upper house in this election, together with control of the lower house last December, Abe now can move ahead with his ambitious reform plans. A more detailed presentation of his reform objectives is promised for release in September. Despite his control of the Diet, Abe still will struggle to advance the most politically sensitive issues of his agenda, including labor and agricultural reforms, an increase in the sales tax, and the upcoming trade negotiations. He will need to overcome the hesitation of some members of his own party on such matters. Nevertheless, he has the best prospects of any Japanese prime minister in the past quarter century for achieving meaningful and much-needed economic reforms. The situation in Japan looks very bullish for the Japanese equity market.

The Abe government program to restart the Japanese economy, backed by exceptionally stimulative quantitative and qualitative easing by the Bank of Japan, is already showing positive results. Japanese bank lending has registered the largest increase in four years. Monetary easing is evidently encouraging fresh investment. Machinery orders were up 10.5% in May over the previous month. The second-quarter Tankan report (Short-Term Economic Survey of Enterprises), with its first positive reading since September 2011, showed that Japanese business sentiment has brightened. Businesses are now planning to increase investment in plants and equipment as they see strengthening consumer demand and exports. Japan’s first-quarter GDP growth of 4.1% annualized led GDP growth among the globe’s advanced economies.

At its recent meeting, the Bank of Japan confirmed it will maintain its plan of expanding the monetary base at an unprecedented rate of 60 to 70 trillion yen a year as it seeks to shift the economy from nearly two decades of deflation to its objective of a positive inflation rate of 2% a year. This will take considerable time and promises an extended period of monetary stimulus. The Bank stated that the economy is “starting to recover moderately,” exports are picking up, and consumer spending is demonstrating its “resilience.”

Japanese company earnings should improve in this environment. The weaker yen is likely to help overseas earnings. On a real effective exchange-rate basis, the yen has depreciated by some 18% since last year’s high. The continued monetary stimulus will probably lead to further falls in the yen’s value.

After years of deflation and dismal equity market performance, domestic Japanese investors have had little appetite for Japanese stocks. Equities account for only 18% of the financial assets of households. We see this situation changing as inflation starts to rise and the Bank of Japan’s monetary policy depresses real interest rates, while corporate earnings improve. Japanese domestic investors will be likely to contribute to the already strong inflows from international investors and help to sustain a prolonged bull market for Japanese stocks. The correction in Japanese equities that ensued in the last week of May and bottomed on June 14 has been followed by a recovery that, by last Friday, July 20th, had recouped over half of the correction. Year-to-date the broadly held iShares Japan ETF, EWJ, is up 22.6% despite the correction.

In Cumberland Advisors’ International and Global portfolios, we are using the WisdomTree Japan Hedged Equity ETF, DXJ, which includes a hedge against changes in the yen-US dollar exchange rate. This hedge continues to help performance, as does the ETF’s exclusion of firms that derive 80% or more of their revenues domestically. DXJ is up 32.7% year-to-date. We think the Japanese stock market will continue to outperform during the remainder of this year and probably in 2014 as well. We are maintaining maximum overweight positions for Japan in our portfolios.

BY Bill Witherell