Moody’s downgraded Japan’s sovereign debt rating on Tuesday from ‘Aa2’ to ‘AA3,’ citing the budget deficit and buildup in government debt.
According to the Wall Street Journal, as long as the rating stays above ‘A,’ pension funds can continue investing in Japanese government bonds without any trouble. Moody’s new rating is now at the equivalent level of previous ratings issued by Standard & Poor’s and Fitch. Moody’s last downgrade of Japan was in 2002 and its outlook on Japan is now stable. However, S&P and Fitch both have a negative outlook, meaning that further downgrades could be coming.
When the S&P downgraded the U.S., it sent stock markets into turmoil. Even just talking about a potential U.S. downgrade roiled the markets. In case you haven’t been watching your portfolio bounce around, see SPY’s daily NAV returns below:
SPY Daily NAV Returns, 8/1/11-8/23/11
So, now that Japan has joined the countries getting downgraded, how will that affect you? I drew up a table of correlations between the iShares MSCI Japan Index Fund (NYSEArca: EWJ) and a collection of regional funds you might have invested in:
- U.S.: SPDR S&P 500 (NYSEArca: SPY), with a 0.92 correlation to EWJ
- World ex-US: iShares MSCI ACWI ex US Index Fund (NYSEArca: ACWX): 0.96
- Europe: iShares Europe 350 Index Fund (NYSEArca: IEV): 0.90
- Asia ex-Japan: iShares MSCI All Country Asia ex Japan Index Fund (NYSEArca: AAXJ): 0.95
The lowest correlation, at 0.90, is between Japan and Europe. That said, any statistics teacher can tell you that correlation does not imply causality; namely, that a movement in EWJ does not necessarily cause a movement in SPY. They merely tend to move in the same direction at the same time.
So instead, I ran some regressions to determine what percentage of the movement in each of those regional ETFs can be explained by movement in the Japanese ETF. It’s still quite a lot, and we can all thank global trade.
R-Squareds of Regressions of Regional ETFs On Japan ETF
Again, the lowest results are in the European fund and the highest are in the Asian and global funds.
Don’t just take my word for it, though. Let’s look at what happened when the Japanese earthquake and tsunami hit in March.
EWJ obviously tanked. More important to my point, though, is that everyone else got hit too.
So, to return to Moody’s lowering its rating on the Japanese government, it’s easy to assume that a slight downgrade to a generally strong country doesn’t matter much. And who knows, it might not. Or it might.