Why renewed yen weakness is the key to a new equity rally

Market Realist

The Bank of Japan Tankan supports a 2014 Japanese equity rally (Part 8 of 10)

(Continued from Part 7)

The weak yen supports corporate profits

The below graph reflects the history of the Japanese yen against major currencies, to include Japan’s Asian trading partners of China and Korea. Since 2012, the yen has weakened about 30% against most currencies, and even more so against the Chinese yuan. This article considers the importance of continued yen weakness, which may be required to support Japan’s growth in corporate earnings, as well as the stock market rally.

Abenomics and the yen

The initiatives of the new Prime Minister have done much to weaken the Japanese yen and ignite an equity market rally. The central bank’s large-scale bond buying has added much liquidity to the financial system, and the yen has weakened as a result. Corporate profits have grown dramatically, and as we noted in the earlier articles of this series, investment has shown signs of significant recovery and slack production capacity has finally disappeared. These developments occurred as the Japanese yen weakened from 76 to the U.S. dollar to around 103 today. Meanwhile, the Central Bank of Japan expects to repeat in 2014 what it did in 2013, bringing total asset from 220 trillion yen to 270 trillion yen by the end of this year. That’s roughly $2.0 trillion to $2.7 trillion dollars worth of assets—around 45% of Japan’s total gross domestic product. In comparison, the U.S. Fed has purchased up to just over $4 trillion in assets or bonds, or roughly 25% of U.S. GDP. In other words, Japan’s quantitative easing program is about twice as large as the U.S. program relative to the size of its overall economy. That is an aggressive measure.

As the Fed tightens, is Japan ready for more easing?

Plus, the U.S. may conclude its bond purchases by the end of this year, while Japan has recently announced that it will choose to remain silent on the issue of 2015 plans for now. It would appear that the Bank of Japan would first like to see what develops with regard to inflation and economic growth over the course of 2014 before deciding future action. With dramatic consumption taxes rising from 5% to 8% this April, and up to 10% in October 2015, the BOJ would like to see how the economy pans out first, after the first round of tax changes. These actions would probably be prudent. The Bank of Japan doesn’t want to inadvertently cause a collapse of the currency, a collapse of Japan bond holdings, and higher interest rates. For now, 45% of GDP is enough liquidity facilitation. The post-2012 pick-up in profits and investment data might be progressing at a good rate and reflect a good, sustainable trajectory for achieving 3.0%-to-4.0% nominal economic growth in an environment of 1.0%-to-2.0% inflation. That would be a great near-term achievement for the Bank of Japan.

To see how Japanese equity ETFs have been outperforming Chinese and Korean equity ETFs since 2013, please see the next article in this series.

For an overview of the U.S. macroeconomic recovery that could support Japan’s export economy, please see 2014 US macro outlook: The crack in the debt ceiling.

Japan’s equity outlook

As 2014 progresses, investors could see a continued outperformance of the Wisdom Tree Japan Hedged (DXJ) and the iShares MSCI Japan ETF (EWJ) versus China’s iShares FTSE China 25 Index Fund (FXI) and Korea’s iShares MSCI South Korea Capped Index Fund (EWY). For further clarification as to why DXJ could outperform both EWJ and other Asian equity indices, please see Why Japanese ETFs outperform Chinese and Korean ETFs on “Abenomics.” Plus, as Japan pursues unprecedented monetary expansion and the U.S. Fed tapers its bond purchases, Japanese equities could also outperform broad U.S. equity indices, as reflected in the State Street Global Advisors S&P 500 SPDR (SPY), State Street Global Advisors Dow Jones Index SPDR (DIA), and Blackrock iShares S&P 500 Index (IVV). For more on how the U.S. Fed’s recent announcements could impact global equities, please see Will the Fed take a bite out of Apple?

Continue to Part 9

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