The WisdomTree Japan Hedged Equity ETF (DXJ) was all the rage the first five months of the year. But since then, Japan’s benchmark index—the Nikkei 225—and Abenomics, to some degree, have lost some of their luster, and it’s become clear that DXJ is not bulletproof.
On May 22, the favorite trade of the year—short-yen and long-Japanese equities—unwound hard, as investors got spooked when 10-year Japanese government bond (JGB) yields spiked to 1 percent and Federal Reserve Chairman Ben Bernanke first mentioned the dreaded “taper” word.
Since then, as of Aug. 15, the Nikkei is down close to 12 percent, and the yen has rebounded more than 4 percent. During that same time period, DXJ is down 12.7 percent, while DXJ’s nonhedged competitor, the iShares MSCI Japan ETF (EWJ), is down only 6.2 percent.
EWJ held up better here because in un-hedged ETFs fully exposed to the yen, a strengthening yen (meaning a falling U.S. dollar) simply offsets the losses from falling equity prices to some degree.
Just to be clear, it’s not that DXJ’s holdings are necessarily more volatile than EWJ’s. It’s just that the Nikkei has been highly volatile since May, and because DXJ takes the currency equation out of the fund’s returns, DXJ’s equity exposure is purer, so it mirrors the local benchmark more closely.
In Japan, there’s been an inverse correlation between equities and the yen for some time now. That being the case, as long as this inverse relationship continues, EWJ tends to be a de facto lower-volatility option to invest in the highly volatile Japanese equity market.
One of the initial steps of Abenomics was to weaken the yen with massive monetary stimulus in order to spur growth (and of course, attempt to kill the deflationary spiral that’s gripped the nation for the better part of two decades).
As expected, as the yen plunged, Japanese equities surged and currency-hedged products like DXJ massively outperformed un-hedged ETFs that were fully exposed to the depreciating yen.
But I’ve long felt that the strong rebound in Japanese equities from a plunging yen only represents the first phase of Japan’s “recovery.” However, the second phase of Japan’s recovery, likely to be more volatile, will probably require serious structural changes in order to succeed.
The Bigger Picture
In a recent IndexUniverse interview with Jeremy Schwartz , director of research at WisdomTree, the general takeaway was that there’s still uncertainty around Abe’s structural reforms, and changes wouldn’t come easy.
I couldn’t agree more.
In fact, I touched on a few of the same issues he talked about in a previous blog , so I won’t reiterate. That said, while I won’t dive into the politics behind Abenomics, there are a few bigger themes I think are worth pointing out.
The first theme deals with the relationship between consumption and demographics. Spurring consumption is clearly a centerpiece of Abenomics, but herein lies the conundrum:How do you spur consumption in a nation where the population is not only shrinking, but also aging fast?
There’s a reason why the Japanese are savers and uber risk-averse. Why would retired folks or those nearing retirement splurge on spending, or even throw their savings into a stock market that’s still a third of where it was in 1990?
I still haven’t heard how Japan is planning to deal with its massive demographics problem, which is really at the heart of much of Japan’s problems. It seems there’s nothing on Prime Minister Shinzo Abe’s agenda around immigration reform in a country virtually closed to immigrants.
The Bank of Japan is also desperately trying to spur inflation, but it needs to keep bond yields low so the country can finance its massive debt burden. Its debt-to-GDP ratio is already in the 240 percent range. The last time 10-year JGB yields spiked to 1 percent in late May, the Nikkei 225 Index plunged more than 7 percent in one day.
Even more unnerving was the mixed messages we got from Japanese officials in the aftermath of that event, suggesting a sense of confusion and discontent among the leaders.
Finally, as Schwartz pointed out, the Japanese themselves have largely been on the sidelines throughout this rally, meaning thus far, the Nikkei surge has largely been driven by foreigners.
This is something I’ve long suspected. After just returning from Japan myself, my suspicion hasn’t changed. In fact, while there was certainly a lot of buzz around Abe, the general takeaway I got from talking to folks in Japan was outright skepticism around Abenomics in the long run.
I would certainly feel much more confident about the sustainability of the Nikkei’s rally if the Japanese started participating. In the meantime, I wouldn’t be surprised to see Nikkei volatility continue as long as foreigners are dominating the trading tape.
I sometimes wonder if the reason the short-yen/long-Nikkei trade unwinds so much when the market swings into risk-off mode is because that’s such an overcrowded trade by so many foreign institutions and hedge funds.
The Takeaway, And Back To ETFs
As we all wait to hear from Abe about his reforms, there’s no way to know whether the recent Nikkei lull is a temporary consolidation phase, or a precursor to choppier waters ahead. But I think the bigger takeaway here is that Abenomics is not a slam dunk by any means.
While I have no doubts about the Bank of Japan’s commitment to its stimulus, I’m also not totally convinced (at least not yet) that the yen is going to plunge into the abyss. It’s worth noting that the yen has already plunged close to 30 percent in a very short time frame.
So getting back to ETFs, for those still interested in Japan, for the second phase of Japan’s recovery, the case for currency-hedged ETFs like DXJ is just not as compelling as it was last year.
While investors in EWJ will likely sacrifice returns on the upside if the yen resumes its plunge, if Abe’s structural reforms fall short of market expectations and the short yen/long Nikkei trade unwinds further, EWJ is likely to see less volatility on the downside.
Of course, if the day should ever come when we start seeing the Nikkei fall in unison with the yen, best of luck to anyone investing in Japan.
At the time this article was written, the author held no positions in the securities mentioned. Contact Dennis Hudachek at email@example.com, or follow him on Twitter @Dennis_Hudachek.
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