The last 12 months have been difficult for the international equity markets, with the benchmark, iShares MSCI ACWI ex US (NASDAQ:ACWX), down 10.15% as of June 2st. Japan’s equity market has also struggled during this period, as Japan’s economy remained sluggish and the yen strengthened some 14% against the US dollar despite policy makers’ wishes to see a weaker currency and a stronger economy. The largest total-market ETF, iShares MSCI Japan (NYSE:EWJ), is down almost 9% over the past 12 months. Recall that when the yen strengthens against the US dollar, the return for US dollar –based investors increases, and vice-versa. Therefore, the decline was even greater for theiShares Currency Hedged MSCI Japan (NYSE:HEWJ), the ETF hedged to remove the effects of yen-US dollar exchange rate fluctuations. It is down 22.45% over the past 12 months.
In May we began to see a slight improvement, with EWJ up 3.2% for the month, while ACWX was still down by 1.2%. Currency-hedged ETFs were up more than twice that amount, as the yen was down almost 4% over the month.
On June 1st Prime Minister Abe announced at a press conference that the second consumption tax increase, scheduled for April 2017, will be postponed to October 2019. This widely anticipated move was justified, according to Abe, because of the continued weakness of the economy due to soft global demand, particularly from China and other Asian emerging markets. The postponement effectively passes the buck to Abe’s successor and puts on hold efforts to address Japan’s chronic budget deficits. While the delay is a concern, Abe is probably correct in concluding that Japanese consumers, and hence the economy, are not in a strong enough position to bear higher taxes. Consumer sentiment held steady in May but has been on a modest downward trajectory since December, despite gains in real wages and household income. Reversing the rising household savings rate will be key to achieving stronger economic growth.
The market was not kind to Abe last week. Investors had already built into prices the widely forecast postponement of the tax increase. They were not at all pleased with Abe’s other remarks on fiscal policy. He said that comprehensive and bold economic measures would be considered in the second fiscal year 2016 supplementary budget, but he offered no details. Investors expected some indication of the likely scale of such measures, which are forecast by some to amount to 5–6 trillion yen ($45 bn–$54 bn). Instead he offered nothing new. Japanese equities sold off, and the yen strengthened. The US jobs numbers released Friday dealt Abe another blow as the dollar immediately tumbled the most since December, dropping 1.8% to 106.93 yen.
These short-term market reactions have not changed our positive outlook for Japan equities in the coming months. The dollar’s strengthening versus the yen that we have anticipated may be pushed back somewhat, but a rate of 115 by year end still looks possible to this writer. On one side, the US economy is strengthening (despite today’s job report). We now expect that the Fed will be ready to make its next rate increase in September. Japan will very likely announce a large fiscal spending package in the coming months. The Bank of Japan looks very likely to add to its already massive monetary stimulus, largely through purchasing further equity ETFs and corporate bonds.
In its latest Economic Outlook published last week, the OECD notes that the Japanese economy’s “engines of growth remain in place… With the working-age population falling more than 1% a year, employment growth has been sustained by higher labor force participation, particularly among women.” As noted earlier, real wages and household income are rising. Moreover, “Corporate profits remain near their record high.” Uncertainty about China’s and other Asian emerging markets’ growth prospects, and about the future value of the yen have undermined business confidence. However, both the OECD and the Asian Development Bank are projecting that China’s further deceleration will likely be quite gradual; and forecasts for other major economies in Asia, such as India, Indonesia, and the Philippines, have been upgraded. Together with our expectation of a weaker yen, the outlook for export growth should improve. Business investment picked up in the second half of 2015 and then fell by 1.4% in the first quarter. We expect it to recover in the second half and strengthen considerably in 2017. The economy should expand by 1.5% this year, according to the OECD, about double last year’s 0.8% advance.
We see the basis for Japan’s equity market to strengthen in the second half of this year and in 2017. We are maintaining our Japan overweight in our International Equity ETF portfolios. Our expectations for a weaker yen make the currency-hedged Japan ETFs look attractive. We like the WisdomTree Japan Hedged Equity Fund, DXJ, which focuses on dividend-paying companies. We are also looking at Japanese small caps. The WisdomTree Japan SmallCap Dividend (NYSE:DFJ), has been significantly outperforming the broad market over the past 12 months. There is now a currency-hedged version of this small-cap ETF, WisdomTree Japan Hedged SmallCap Equity (NASDAQ:DXJS), but it still has rather limited liquidity.