Japan may be facing the first real hiccups in an ambitious economic growth plan that kicked off under Prime Minister Shinzo Abe’s leadership earlier this year. That said, the amazing story of revival of an economy long mired by slow growth and deflationary pressures is far from over.
In fact, to hear WisdomTree’s Director of Research Jeremy Schwartz tell the tale, there are plenty of incipient signs that Japan’s revival is just getting started. Schwartz told IndexUniverse’s Cinthia Murphy in an interview this week that it will be late July before anyone really knows what cards Abe is going to play to spur growth in the Japanese economy.
Until then, Schwartz says it’s entirely realistic to expect more market volatility as the world’s third-biggest economy works out the finer details of its economic plans and the further success of yen-hedged ETFs such as the $9.35 billion WisdomTree Japan Hedged Equity Fund (DXJ) hang in the balance.
IndexUniverse.com:The Nikkei has fallen more than 12 percent since late May; Japanese bonds are volatile; the yen doesn’t seem to be moving in a single direction anymore. Are these bumps in the road to be expected?
Jeremy Schwartz :Volatility in markets is to be expected. Markets don’t move in a straight line, or in one direction forever. A lot of what’s happening in Japan is a long-term strategy—they are just getting started with implementing the new policies, and so far, economic data coming out of Japan is showing that Abenomics is working.
GDP numbers came in recently better than expected, the current-account surplus doubled versus the previous year—also better than expected; consumer numbers are better. Economic data is all pointing in the right direction. But the market reacts in different ways. From my perspective, nothing has really changed in terms of Japan’s outlook. It’s a long-term strategy, and they are just getting started.
IU.com:What’s the next milestone we should be looking for in this Japanese recovery?
Schwartz: [Prime Minister Shinzo] Abe has what he calls a “three-arrow” policy—a concept that’s based on an old Japanese legend about three arrows being harder to snap than a single one. And the third arrow is his “growth” strategy—the first two were “monetary stimulus” through the Bank of Japan, and “fiscal stimulus” from the government side.
This third arrow is still being formulated, and we know little about how Abe is going to pursue growth. There’s a parliamentary election July 21, and I don’t expect to see the boldest of his growth strategy happen until after that election. I’d look at the second half of the year, as the time frame for when we are going to see what they have up their sleeves to deal with some of the big structural changes Japan needs.
Japan has to deal with an aging demographic; high uncompetitive tax rates; tax incentives to increase foreign investment in the country—a lot of this is going to play out in second half of the year. They’ve only been doing the monetary policy stuff right now.
IU.com:I’ve heard that the BOJ is hoping to keep the yen between 100-to-110 yen to $1. Is that a real target, because we’re not that far from that?
Schwartz: I don’t know that there’s actually an explicit target for the yen. There’ve been different comments going around, and that’s confusing the market. But if you look at where we were pre-financial crisis, the yen was at 120 to the dollar, and we are just now getting back to 100. I would not be surprised to see the yen ultimately revert back toward 120.
They’ve been successful at getting the currency to weaken from substantial highs through rhetoric and policies—they can’t directly control the currency markets. But there are a lot of things that are beyond their control. If you have an improving U.S. economy relative to Japan, you could see another leg in the currency move that Japan can’t control. That makes it hard to put an exact target on the yen.
IU.com:Assuming the yen hits 120 to $1 and stabilizes there, will a currency-hedged strategy like DXJ continue to make sense, versus unhedged equities exposure through funds like EWJ?
Schwartz: Currency hedging is becoming more and more important. Japan is a clear example of that because you have currency weakness that corresponds to equity strength—it’s a negative correlation. But the question really is, Why is it the natural default to have exposure to currency risk unless you have a strong conviction that the currency is going to appreciate?
If you don’t have a view, it’s better not to have the currency risk, and just take on the equity risk if that’s what you think is going to appreciate. If you go back to where Japanese equities were pre-U.S. financial crisis, the Topix—their broadest market index—was at 1,800 in 2007, and today it’s at 1,112. That’d be a rally of more than 60 percent from today’s levels just to get back to pre-crisis levels.
There are more and more stories emerging about Japanese companies looking to get back to their pre-crisis profit levels, and if profits are rising, I don’t see why the equities market can’t get back up there as well. Long-term prospects are positive.
IU.com:Abenomics has raised expected inflation, lowered short-term interest rates and improved Japan’s fiscal position. What are the main risks going forward?
Schwartz: The central risk is that Japan is one of the most indebted countries in the world. They have a high deficit—they do a lot of spending—and they have to fund that deficit spending through the issuance of new debt, and yet they also have one of the lowest interest rates in the world. So there’s this conundrum when people talk about high-indebted, high-interest-rate countries—Japan is a high-debt, low-interest-rate country.
Abe and his team are talking about buying Japanese bonds to keep prices high and yields low, but if they are successful in generating inflation, that would put pressure on interest rates to increase overtime. How they manage that relationship between generating inflation and generating higher yields in the bond market, as they try to pay down their debt, is one of the big challenges here.
If they’re going to have growth, they need to get out of this deflationary trap they’ve been in. They need inflation, and rising yields could be a sign of success as they work to get out of deflation.
IU.com:Can Abenomics control the factors that impact JGB yields, such as risk tolerance and time preference?
Schwartz: Interest rates are low globally, at historical lows, and Japan’s rates are the lowest. If you have any normalization in global yields, Japan is suspect for that. But deflation has been a powerful force that has kept yields quite low; if inflation materializes, yields will likely rise.
What’s really interesting here is how much money is actually invested in Japanese bonds. More than 60 percent of pension fund assets are in Japanese government bonds, and only 10 percent or less are in equities. As that exposure shifts more towards equities—something the government is hoping will happen—will that put pressure on bonds? Or are these pension funds just going to wait until bonds mature?
We don’t know. How it all plays out will be a big factor impacting the bond market. Abe is trying to stimulate the economy, and over time that should put pressure in the bond market.
IU.com:As far as DXJ’s 7 percent slide last month alone, that’s nothing to worry about?
Schwartz: I’ll go back to that pre-crisis Topix level of 1,800—that’s a 60 percent rally from here to get there. It’s not going to be a straight line, but I believe we’ll eventually get there. Companies have to keep showing profits growing, and expectations are rising, but a lot of them are exporters, so a weaker yen and improving global markets will be important, but equities will continue to do better over time, in my opinion.
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