Structure Matters: Schwartz On DXJ & Hedging

May 06, 2014

Weiskopf: What things are you looking for out of the Bank of Japan, from a research standpoint, that would provide evidence that what’s going on in Japan is sticking?

Schwartz: I think the current valuation case in Japan is one of the more interesting, from a global markets perspective.

Last year in the U.S., there were strong gains—32 percent for the S&P 500—but most of it was multiple expansion. In Japan, despite a huge rally, you had multiple compression as earnings went up faster than stock prices. Today, DXJ—on an estimated earnings basis—is trading around a 30-year low multiple at 13 times earnings versus the S&P at about 16 times, and even cheaper compared to Europe.

Only the emerging markets are truly cheaper, but recently many have been fearful about the emerging markets. Japan’s headed in the right direction on the earnings front.

Now, I think when you look at what Abe is doing, a lot of it is actually working. He has his three-arrow policy of aggressive central bank easing. There’s been no question the central bank was a dead bull’s eye in their approach. They completely changed the dynamic about a year ago when they implemented shock-and-awe quantitative easing.

Moreover, they’re not just buying bonds, they’re buying ETFs. The Bank of Japan owns 40 percent of the entire ETF market in Japan. So talk about a bold statement about ETFs; if Janet Yellen came out saying, “I am going to buy the S&P 500,” that’s essentially what the Bank of Japan is doing.

Japan just announced a new consumption tax hike that people are concerned about, from 5 to 8 percent. Abe has talked about how he wants to target a 25 percent corporate tax rate. They want to shift the tax burden away from the corporations.

They want to make Japan a haven for investment over Hong Kong and Singapore. They know they’ve got high debt-to-GDP, so they’ve got to balance this out. They have no choice but to get inflation going in a positive direction.

They were successful in the first year by getting inflation to a 1.5 percent level, which helps to grow tax revenue. Amazingly, they’ve kept the Japanese bond yields at 60 basis points. It’s bad if you’re a holder of JGBs; you’re suffering a negative real return.

However, it’s great for the government because it buys them some time. What they’re doing is going in the right direction. They’re going to try to make the corporates more profitable. If they’re going to affect corporate tax revenues, that’ll hopefully fuel a broader economic growth—and keep them out of the deflationary cycle.

Bottom line: The program seems to be on track and will continue to be a strong region for profit growth at the most reasonable valuations. There is still an apparent negatively correlated currency-equity market. The case for Japan starts with the yen staying flat to weakening.

That is not to say the yen and equities could not go in the same direction at some point in the future and currency hedging would be less important, but not from current levels.

If the yen were 120 or above, maybe the yen could go up and the stocks and currency go in the same direction, but not from 100 where you are currently. I think the current situation still argues for currency hedging.


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