This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today’s article features Tyler Mordy, president and co-chief investment strategist of Toronto-based Hahn Investment Stewards.
Today’s great paradox is that the longer “secular stagnation” persists, the higher asset prices will likely rise and the higher the risks of major policy exits. To be sure, this is not an argument driven by bullish perspectives on the real economy. It is a recognition that the sponsorship of rising global asset markets by the world’s monetary authorities will continue for some time. Central banks are all in.
Japan is the leading case in point. Despite all the fanfare of Abenomics, the country entered a triple-dip recession in 2014 and Abe is now backing away from key structural reforms. Clearly, not all three arrows are soaring in flight.
That means Japan’s policies may now be nothing more than dressed up currency debasement (albeit draped with the prestige of Japan’s monetary mavens). Still, the stock market benefits from this competitive-devaluation approach. While currency depreciation is a cheap thrill, it is also a crowd-pleasing elixir.
True to form, the yen’s near 30 percent decline over the last two years (on a trade-weighted basis), uncorked a party in the stock market. Billions of dollars flooded into WisdomTree’s currency-hedged flagship Japan ETF (DXJ | B-57), which tracks an index dominated by the large-cap, exporting sector.
By comparison, Japan’s small cap ETFs have seen much more muted inflows. Yet, there is a strong case for ETFs like WisdomTree’s Japan Hedged SmallCap Equity ETF (DXJS | C-48). Why is this so?
First, while everyone seems to grasp the macroeconomics of Japan, few understand the micro. Over the last decade, Japanese companies faced the twin burdens of chronic deflation and an overvalued currency. What has been the result?
Unsurprisingly, corporate Japan is now extremely lean and efficient. Aggregate Japanese return on equity has been trending upwards as companies have focused on improving corporate governance and benefitted from a weak yen. At 8.5 percent, overall return on equity (ROE) is quickly approaching double-digits, a level that has only been eclipsed twice in the past 25 years.
MSCI Japan JPY Total Return Vs. ROE
Second, Japan is a veritable hotbed of companies at the forefront of several technologies reshaping the global economy—including robotics, electrics cars and alternative energy. While those firms benefit from a weaker yen, they are not entirely dependent on it.
Third, Japanese small-caps are priced at the frontier of value, if not over the edge – deep into bargain territory. DXJS trades at a weighted average price/book of 0.98—less than half of the 1.83 world average (as measured by the MSCI ACWI Small Cap Index).
Fourth, the plunge in oil prices is indisputably positive for Japan, which imports most of its energy needs. On the surface, lower oil prices will deliver a boost to Japan’s current account and increase real wages, but domestic companies will benefit most as the energy price disadvantage they suffer narrows against foreign rivals (most notably, firms in the United States).
Finally, Japan is likely transforming itself from a nation of savers to a nation of investors. Contrary to popular belief, the Japanese savers have never been wealthier, having a net worth that is double what it was at the peak of the 1980s bubble. This marks the big difference between Japanese private savers and their counterparts in other countries. While more than a third of savers in the UK or the U.S. buy stocks, less than 10 percent of Japanese people do.
Viewed another way, a mere 8 percent of Japan’s household wealth is invested in equities, compared with more than 30 percent for the U.S. Abe is now inviting—even insisting—that millions of households funnel their savings into Japanese stocks via the tax-free NISA savings account program. A veritable tsunami of domestic investment is coming. Targets will hardly be limited to the large-cap sector.
This, of course, is all part of Abe’s master plan. A rallying stock market stokes “animal spirits” (that colorful name Keynes gave to human overconfidence), which in turn should lead to wage increases, capital investment and, ultimately, an increase in the return on invested capital. That's the theory, anyway. But don't bet on it.
However, we do believe that the Bank of Japan will continue to aggressively underwrite a rising stock market. Couple that familiar macro story with strong micro underpinnings and Japan’s small cap sector looks set to prosper.
Tyler Mordy, president and co-chief investment officer of Hahn Investment Stewards, is an expert in the design and application of global macro ETF managed portfolios. He is interviewed by the financial media for his global investment strategy views, as well as ETF trends. CNBC has called him one of the “best independent ETF experts.” Contact Hahn at hahninvest.com/contact.