The Japanese economy has been a basket case for decades, afflicted by an aging population, zombie banks and fading multinational companies. The country's stock market has reflected the dismal economy, and the Nikkei index still languishes far below its peak of nearly a quarter-century ago.
Japan's economy is still a basket case. But its stock market is now the hottest thing going, up 16 per cent this year in Canadian-dollar terms. Many investors believe that its ascent has just begun, as controversial macroeconomic policy lays the foundation for an extended bull run.
"If I was forced to own one stock market, it would be the Japanese stock market," says Jeffrey Gundlach, the superstar investor and CEO of DoubleLine Funds.
Mr. Gundlach specializes in bonds, not equities, and his bullishness on Japan's stock market – which started last fall, before a 50-per-cent gain – is based on the fact that even with the recent rally, the S&P 500's return since 1989 has outpaced the Nikkei by 15 times. "I've just gotta believe Japanese stocks are cheaper than U.S. stocks," he said in a conference call last month to investors in his funds.
Mr. Gundlach's larger theory is that Japan is in the lead as countries around the world begin to devalue their currencies in what he calls "the big easy, the great debasement." Japan "is the pace car: The demographics are bad, there [are] no private savings pool, there's massive government debt, and there's a trade deficit. The only thing left is debasement."
The more polite term is Abenomics. The Japanese elected Shinzo Abe as prime minister in December after he campaigned on the rather remarkable pledge to increase inflation in attempt to get the country's moribund economy going. He's attempting to deliver: Earlier this month, the Bank of Japan said it plans to double the country's money supply, an announcement that once again goosed the country's stock market. His government also plans significant deficit spending to boost GDP.
The first, most tangible result of Abenomics has been a free-fall in the value of the Japanese yen, which has dropped roughly 20 per cent against the U.S. dollar. All things being equal, that's like an automatic price cut for Japanese exporters, whose goods become cheaper in international markets as the yen falls. Over the past few years, the Tokyo market has moved in sync with the yen-U.S. dollar exchange rate, and this time looks to be no different.
Investors who want to play this trend should keep two things in mind: Japanese companies that export will be the prime beneficiaries of the falling currency, and investment vehicles that hedge against a falling yen are better-positioned than others to put returns into your wallet.
For most investors, the easiest way to ride this macro trend is to choose an exchange-traded fund (ETF) or mutual fund that holds a broad swath of the Tokyo Stock Exchange.
The iShares Japan Fundamental Index Fund ETF, for instance, contains more than 250 Japanese stocks, selected on the basis of a "fundamental" index, that weights its holdings based on factors such as dividends, cash flow and sales. Three of Japan's best-known exporters – Toyota Motor Corp., Honda Motor Co. Ltd., and Hitachi – are among its top five holdings.
The fund is currency hedged, so changes in the yen should not affect Canadian-dollar returns, and is also cheap, says Rudy Luukko, editor for investment and personal finance at Morningstar Canada. The expense ratio for its common shares is just 0.72 per cent.
Mr. Luukko notes, however, that the ETF has been one of the poorest performers among Japanese-focused Canadian mutual funds and ETFs over the last five years, with an annualized loss of 6.4 per cent. "It's been a worse loser than average in a losing category, despite the advantage it's enjoyed through low fees."
A mutual fund that combines low expenses and a history of performance is the TD Japanese Index (e series), Mr. Luuko says. The fund, which charges a 0.52-per-cent expense ratio, is in the top 25 per cent of its peers in the last five years. It's market capitalization-weighted, and is based on the MSCI Japan Index. But it is not hedged against the yen's decline.
Canadian investors who don't mind taking on another type of currency risk may want to consider a southern option: the Japan Hedged Equity ETF offered by WisdomTree Investments Inc. It is hedged against the yen's decline, but in terms of U.S., not Canadian, dollars. Better yet, it decided last fall to tilt its fund toward Japanese exporters by tossing out companies that derive more than 80 per cent of their revenue from Japan.
"We believe Japan-based multinational companies that generate the bulk of their revenues from markets outside of Japan are more likely to benefit from a weakening yen," WisdomTree's research director Jeremy Schwartz wrote in November, explaining the move.
The WisdomTree ETF is well positioned to benefit if Abenomics sparks a Japanese export boom and should do even better if the new government's monetary shock treatment succeeds in jolting the Japanese economy back to life. But many observers suggest investors should be cautious, given Japan's problems – which span greying demographics, weak corporate governance and lack of consumer demand – are far from solved.
Julian Jessop of Capital Economics sees the yen continuing to weaken through 2014, something that "at face value … is unambiguously positive for Japanese equities." But, he says, "yen weakness alone may not be enough to sustain an equity market rally … Higher prices could actually undermine the economic recovery, if they are not soon matched in wages and profits."
Mr. Gundlach, however, compares the current situation to watching natural gas go from $2 per Mcf to $2.50, wishing you'd bought at $2, then watching it go higher. "You can say you need growth and prosperity for stocks to do well, but don't say that out of one side of your mouth and say quantitative easing is the reason to own the S&P 500 out of the other side of your mouth," he says. "The long-term trend seems to be powerfully in favour of Japanese stocks."
David Milstead