This commentary was written by Bill Witherell, Cumberland’s Chief Global Economist. He joined Cumberland after years of experience at the OECD in Paris. He can be reached at Bill.Witherell@cumber.com.
At last week’s gathering of central bank presidents in Jackson Hole, the European Central Bank’s Mario Draghi and the US Federal Reserve’s Janet Yellen stole the limelight. Rather less press attention was paid to the remarks of Bank of Japan Governor Haruhiko Kuroda, whose monetary policies have been largely responsible for the recovery of the world’s third largest economy (after the United States and China).
An expansive quantitative easing program, one much bigger relative to the size of the Japanese economy than the quantitative easing undertaken by the Federal Reserve, has been the one element of Prime Minister Abe’s economic program (“Abenomics”) that has clearly been successful. QE is the first “arrow” of the program. The other two “arrows,” fiscal policy and economic reform, have been notably less effective. Economic reforms have been modest thus far, and the net effect of fiscal policy has been negative due to the consumption tax increase in April.
In recent weeks, as the extent of the second-quarter pullback in the economy became evident, an increasing number of observers have asked whether “Abenomics” is failing. Friday’s lead editorial in the Financial Times was titled “Abe must keep his project on track – Japan’s economic recovery hangs in the balance.” It is evident that moving the economy onto a positive and sustainable growth path will require the Bank of Japan to maintain, and probably increase, its massive monetary stimulus well beyond the end of this year.
Kuroda’s remarks at Jackson Hole imply that the BOJ is committed to this course. “We will continue our current monetary policy, but if there is anything which could derail our course toward the 2% inflation target, we will not hesitate to change or adjust our policy.” Furthermore, he noted that the BOJ’s monetary easing policy might have to be pursued “for some time.” That will be necessary to get to the point where “inflation expectations are anchored to 2 percent.” He explained that creating and maintaining the expectation that inflation will continue at a positive, if modest, rate for the foreseeable future is essential to get firms to raise wages and invest rather than to continue hoarding cash.
It looks very likely to us that reaching and staying at a core inflation rate of 2% will require additional monetary stimulus. That course will keep interest rates at a very low level, stimulate the Japanese economy, and be positive for asset prices. Even if the 2% target proves to be elusive, as some economists argue, Japan should see an end to the deflation that has had such a destructive effect on its economy.
Of course, Abe should not rely solely on the central bank to keep his economic recovery program on track. He needs to sharpen and accelerate the economic reform “arrow” of Abenomics, focusing in particular on the labor market. Also, in view of the experience with the first of two planned increases in the consumption tax, he may find it prudent to delay or cancel the second increase, a move from 8 to 10%, scheduled for next year. It would be better to wait until consumer spending has a stronger basis of rising real wages.
As the economic recovery appeared to stall in the second quarter, many individual investors decided to close their Japan equity market positions. Institutional investors were less quick to depart. Despite concerns about the recovery, the Japan TOPIX Index is up 10% over the past three months, a period when the S&P 500 gained 5.5%. The latest flash (August) Japan Purchasing Managers’ Index for Manufacturing is the strongest since March, with output and new orders rising sharply. This suggests the economy is resilient, recovering quickly from its second-quarter swoon. While we expect the Japanese economy will advance at a very moderate pace in the coming quarters, corporate earnings are expected to remain strong.
At Cumberland, we remain positive about Japanese equities and are maintaining the significant Japan positions in our International and Global Equity ETF portfolios. Along with the expected general effects of the monetary stimulus program on the economy, the Japanese equity market is receiving support from the BOJ’s purchases of equity market ETFs. (Consider what the effect would be if the Fed started buying US equity ETFs.) . Also, the government pension plan is increasing its allocation to domestic equities.
US investors now have some 19 Japan equity market ETFs from which to choose, not counting leveraged or inverse ETFs. The two most liquid by far are the iShares MSCI Japan ETF, EWJ, which is up 2.6% over the past six months, and the WisdomTree Japan Hedged Equity Fund, DXJ, which is up 5.12% over the same period. DXJ is hedged against changes in the yen-US dollar exchange rate, and its holdings are based on dividends. A currency hedge looks prudent to us.
Our outlook for continued and expanded monetary stimulus implies further depreciation of the yen versus the US dollar in coming months. The Deutsche X-Trackers MSCI Japan Hedged Equity ETF, DBJP, is another total market-hedged ETF that has good liquidity and a lower expense ratio. It is up 4.04% over the last 6 months. The small-cap sector in Japan is also worthy of consideration. The most liquid ETF is the WisdomTree Japan SmallCap Fund, DFJ, which is up 7.10% over the past six months. The hedged alternative, the WisdomTree Hedged SmallCap Equity Fund, DXJS, was launched just last year and is considerably less liquid. It is up 7.81% over the past six months.
Photo credit: Les Taylor