Tokyo Rose

  By Guest Blogger Doug Rowat

Japan is accustomed to sudden, rapidly escalating disasters: earthquakes, tsunamis, Fukushima, radiation, Godzilla.

Unfortunately, Japan is also equally plagued by slowly escalating disasters, in particular, its aging population problem. Japan’s Ministry of Internal Affairs recently reported that the age 70-and-over segment now makes up a remarkable 20% of the country’s population. And the 65-and-over segment is also now at an equally astounding 28%, which has steadily crept up from 22% just a decade ago. As a point of comparison, less than 9% of the world’s population is currently 65 and older. In short, Japan is a country of Methuselahs.

As a result, inflation has remained persistently low and Japan has fallen into four recessions in the past decade. It’s presently attempting to dodge its fifth. So, clearly, Japanese equities have been terrible investments over the past decade.

Except that they’ve been great investments. Despite all the problems listed above, Japanese equities have been stellar performers. The Nikkei 225 has returned 10.7% annually over the past 10 years on a total-return basis, easily eclipsing the 8.2% annual total return of Canada’s S&P/TSX Composite, for example. Pretty good results for a country that’s averaged only 1% annual GDP growth over this same period.

EAFE (Europe, Australia, Asia, and the Far East) exchange traded funds provide diversified exposure to a wide array of overseas markets. But if you want to own such an ETF (and you should) you have to be comfortable with significant Japan exposure. Most EAFE ETFs have a meaty 20–25% weighting to Japan, so appreciating the drivers of the Japanese equity market is essential.

Prime Minister Shinzo Abe’s long-running and aggressively stimulative economic plan, Abenomics, has contributed to the strong Japanese equity performance in part because Abenomics has weakened the Yen, which has been positive for corporate profitability. Japan is an export-reliant economy, so a weaker Yen equals more earnings growth. Toyota Motor, as an example, sells 75% of its vehicles outside of Japan.

But perhaps the main reason for the impressive equity market performance has been the massive stimulus from the Bank of Japan.  The correlation between the BoJ’s balance sheet and the Nikkei 225 isn’t perfect, but it’s pretty close. 94% to be precise. And, as the Japanese economy remains fragile, the BoJ has been called on to further ramp up its monetary easing. And the BoJ seems willing to oblige. BoJ Executive Director Eiji Maeda addressed the Japanese parliament in April and was blunt: “If the economy’s momentum…is threatened, we are ready to ease monetary policy as necessary.” Unusually strong and clear language from a central bank.

Bank of Japan total assets (white line) vs Nikkei 225 (orange): a 94% correlation over 10 years Bank of Japan total assets (white line) versus Nikkei 225 (orange): a 94% correlation over 10 years

Source: Bloomberg

The long-term consequences of the BoJ’s monetary policy, of course, are unknown, though it’s already hurting the commercial banking sector. However, we remain satisfied that, at least for the near to medium term, the well-established and strongly positive relationship between the BoJ’s asset levels and the Nikkei 225 will continue. The BoJ stimulus, of course, may eventually derail the Japanese equity-market bullet train, but until then, it’s fun to travel at 200 mph.

Japan is also consistently one of the world’s largest net importers of oil and, of course, its dependence on oil was exacerbated after the massive 2011 earthquake and tsunami, which took most of its nuclear energy production offline. The vast majority of its reactors are still shuttered. Therefore having some Japan in your portfolio also provides an effective hedge against the oil sector. Over the past 10 years the Nikkei 225’s correlation to oil has been sharply negative.

Japan: Negatively Correlated to Oil Prices

But the oil hedge is a side benefit. The main reason to own Japan is the expectation that the BoJ’s monetary easing will continue.

Japan serves as a good reminder that while fundamentals (and demographics) matter, central banks matter more.

Finally, as of this writing, James Holzhauer continues his red-hot winning streak on Jeopardy! He’s now racked up more than US$2.3 million in winnings and has the second longest win streak in Jeopardy! history. He continues to close in on Ken Jennings’s all-time record of US$2.5 million in winnings over 74 consecutive games. For analysis on how Holzhauer’s been doing it, check out my recent blog post.

Doug Rowat, FCSI® is Portfolio Manager with Turner Investments and Senior Vice President, Private Client Group, Raymond James Ltd.