It's time to look more closely at Japan’s amazing rally and DXJ’s stellar run.
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.
Japan is at an important crossroad. The Nikkei index gained 57 percent in 2013, its highest annual return since 1972.
Meanwhile, the WisdomTree Japanese Hedged Equity Fund (DXJ | B-47) raked in more than $11 billion in new assets last year. This launch is the stuff of dreams in the world of fund sponsors.
The stellar performance of Japan’s stock market is no coincidence. Prime Minister Shinzo Abe’s three-arrowed strategy—dubbed “Abenomics”—appears to be working. For now, anyway.
The first two arrows were monetary and fiscal palliatives, designed to defeat deflation and support the Japanese economy. The prescription worked, creating a potent cocktail of surging investor confidence, currency depreciation—the yen slumped 18 percent versus the dollar last year—and, finally, arrested a 15-year streak of persistent deflation.
That was the easy part. Stock market rallies almost always follow aggressive currency devaluation. The two go together like yin and yang, Simon and Garfunkel … or gin and tonic. It’s the fastest way to profit growth and asset inflation.
Yet while currency depreciation is a crowd-pleasing elixir, it’s also a cheap thrill. The party cannot last forever, as exchange rates can only decline so far before other countries start protesting.
Policymakers know this. That’s why the third arrow of structural reform has not yet been fired. Abe knew that fertile conditions were required to push through sweeping policy changes.
Now, tougher medicine, directed at raising productivity—which is desperately needed for a nation with a declining workforce—needs to be administered.
Third Arrow Misfire?
As 2014 unfolds, Prime Minister Abe’s reform policies will be tested by a veritable menagerie of factors.
Some remain convinced that Abe will succeed in his goal of boosting Japan’s long-term growth rate to 2 percent, which would be almost double the rates of Japan’s two “lost decades” since the bursting of its twin property and equity bubbles in 1991. Others remain skeptical.
Where to next? Good analysis always starts with the risks. Some believe the main one is Abe’s apparent squandering of political capital.
In December, he rammed an unpopular state secrecy law through Japanese parliament and then recently visited the controversial Yasukuni World War II shrine, infuriating China and many Asian trade partners. Those actions were enough to drag his popularity ratings to the lowest level since he took office.
Still, those risks are overstated, missing the mark of the current investment climate. Political risks are always present. Today if investors have learned anything, it’s that monetary policy now overrides political tensions.
The U.S. is a case in point. Last year featured a contentious mix of political gridlock and partisan bickering, yet the stock market soared on the wings of quantitative easing.
With this in focus, a fuller analysis of Japan’s situation highlights these immediate risks: