Japan Prime Minister Shinzo Abe has updated the “third arrow” of his economic policy, a wide-ranging package of economic reforms aimed at lifting the growth of Japan’s economy. His first two arrows of monetary and fiscal stimulus introduced last year had an initial positive impact. The core inflation rate in April of 1.5% suggests the goal of 2% is attainable. However, the economic recovery and bull market in Japanese equities stalled, due at least in part to investors’ dissatisfaction with the initial reforms steps.
The revised reforms announced last Monday, June 16, were in the form of a 120-page broad strategy statement – outlining many initiatives but in rather light detail, with few firm commitments. Market commentators criticized the statement as being “too ambiguous” and not sufficiently ambitious. While we also would have welcomed bolder moves, we see the statement as taking positive steps in a number of areas that need reform. There should be more clarity following the June 27 cabinet meeting, which is expected to approve the proposals as formal government policy.
Despite the above hesitations, investors, particularly long-term investors, apparently share our positive and improving view of the Japanese economy and market. So far this quarter, according to the Financial Times, Japan has led other Asian markets in attracting funds, with inflows of $7.2 billion US dollars. Valuations are attractive compared to those in the US. The MSCI equity market index for Japan, while still down for the year, is up 5.12% this month-to-date, much stronger than the corresponding MSCI indices for Europe (+0.68%) and the US (+2.07%).
Particularly welcome, in our view, is Abe’s commitment to reducing the baseline corporate income tax rate by 20-45% over several years, beginning next year. The current rate of more than 35% is the second highest among the OECD countries. The precise extent the rate will be reduced is still under discussion. One possibility that has been mentioned by Abe in the past is the 29% rate of Germany. Another possibility is the OECD average of 25%.
While the corporate tax cut should prove very beneficial eventually, the announced policy change that will likely have the most important positive near-term effect on the equity market relates to the way the $1.3 trillion Government Pension Investment Fund (GPIF) invests its premiums. There is a clear intention to move the GPIF to be more risk-taking and equities oriented. The statement cites a “need for the GPIF to review its basic portfolio and strengthen its governance systems.” Presently, over half of the GPIF portfolio is in low-yielding government bonds. It is expected to move some funds into the JPX-NIKKEI 400 Index of profitable, shareholder-friendly firms. Private pension funds and retail investors are likely to follow the GPIF lead.
There are a large number of other proposals that, while modest, are steps in the right direction: loosening rules on land ownership and conducting a review of Japan’s system of agricultural cooperatives, which are a strong and highly conservative political force that has presented a significant barrier to agricultural reform and trade liberalization; initiating a few cautious actions to begin the much needed liberalization of Japan’s labor market, including giving companies the right to negotiate pay and conditions directly with employees; boosting immigration (modestly) to bring in more skilled workers; and eliminating a tax benefit, a spousal tax exemption, that deters spouses from seeking full-time employment.
We have remained bullish on the medium-term prospects for Japan’s equity market despite the market’s pullback and underperformance until quite recently. The announced reforms have strengthened our conviction for the second half of this year.
There are now a number of ETFs on the US market providing exposure to Japan, including eight that address the total market. The most liquid, by far, since its launch in 1996, has been the iShares MSCI Japan ETF(NYSE:EWJ). It has been our favorite in the past. However, there is, in our view, a significant risk that the Japanese yen will resume its downward drift versus the US dollar, which we expect to strengthen over the next twelve months. A further dose of quantitative easing by the Bank of Japan is quite possible in the third quarter, and that would contribute to a weakening of the yen. Therefore, we prefer to have our Japan position hedged against fluctuations between the value of the US dollar and Japanese yen.
We currently are using the most liquid Japan ETF that includes such a currency hedge, the WisdomTree Japan Hedged Equity Fund (NYSE:DXJ). This fund weights its holdings based on dividends and excludes any companies that earn more than 80% of their revenues domestically. As a result, this ETF underweights financials significantly. An alternative with acceptable liquidity is the db X-trackers MSCI Japan Currency-Hedged Equity Fund (NYSE:DBJP). There also is a newcomer, iShares Currency Hedged MSCI Japan (HEWJ), which is literally a hedged version of EWJ. Both these funds are market-cap-weighted, and thus their sector weights fit closely the market-cap-weighted MSCI index for Japan. Over the past month, a period when the yen was fairly stable, the returns of these hedged ETFs – (NYSE:DXJ): 10.45%, (NYSE:DBJP): 10.82% and HEWJ: 10.64% – were very close to the return for the unhedged EWJ: 10.33%. If the yen does depreciate in the coming months, the returns from these ETFs will diverge, as they did during the previous period of depreciation. Conversely, should the yen appreciate versus the US dollar, the hedged ETFs will underperform.
Bill Witherell, Chief Global Economist