In the first week of February, guess which developed country-dedicated mutual fund attracted the most inflows? Japan. Japan! Remember these guys? The MSCI Japan (EWJ) ETF EWJ 70,92 +0,27 +0,38% is up nearly 5% year-to-date; better than MSCI Europe (VGK) VGK 66,41 +0,11 +0,17% and better than the S&P 500 (SPY) SPY 515,71 +2,85 +0,56%.
Jeremy Schwartz, director of research for WisdomTree says there’s a reason Japan is beating the U.S. and Europe this year.
“Japanese equities are the asset class most geared to rising U.S. rates and rotation out of low-volatility and into cyclicals growth,” he says. “But it is not just this global macro inflection that is pushing up Japanese equities. Japan has endogenous forces supporting a bullish stance on Japanese equities.” Schwartz discuss Japan on Behind The Markets Podcast: Japanese Market Outlook & Building Portfolios.
WisdomTree believes that Japanese corporate earnings are ready to turn positive this quarter. Domestic and global sales growth targets have been quite conservative. Japan Inc. is about to beat them silly. Exporters are budgeting for an exchange rate of ¥103, and every five yen of depreciation adds back about four percentage points to earnings. In other words: against a projected drop in profits of two percent in the fiscal year that ends in March 2017, profits should rise by around five percent this current fiscal year; and an added rise of 15% is likely for 2017.
What else?
Japanese investors are rebalancing their funds. With interest at zero, domestic insurance and pension funds may have no choice but to increase positions in stocks. In 2016, the primary allocation shift was from bonds to non-yen securities. But in 2017, domestic equities are set to become the Japanese asset of choice, says Schwartz. Why? Rising earnings visibility and attractive valuations. The trailing price-to-earnings is now around 17.5x, and forward P/E stands at around 12.5x. Compared to zero-bond yield, the equity market earnings yield gap stands at historic highs.
If the yen depreciates more, this would further boost the case for Japan because exports look attractive.
WisdomTree has its own Japanese-focused fund. Their Japan Equity Hedge (DXJ)DXJ 107,23 +1,66 +1,57% is up 22.6% in six months, while the MSCI Japan is up 4.37%. Here’s there December performance report.
The primary difference between these two major exposures is one has currency exposure (EWJ) and DXJ hedges the yen. Traditional ETFs have not hedged their currency exposure so they have two risk factors — the underlying stocks and the foreign exchange rate.
“When the yen weakens…hedging the yen has helped returns,” says Schwartz.
The other differences come from WisdomTree’s underlying stocks. The MSCI Japan is a market cap weighted index strategy, and the Wisdom Tree product follows a dividend weighted index strategy that also tilts weight to global multi-nationals less reliant on the Japanese economy. WisdomTree’s fund has more exposure to exporters that benefit from a weaker yen.
“Japan multinationals are much more sensitive to U.S. and China economic growth and the yen and less sensitive to the local Japanese dynamics,” Schwartz says. “If we looked at long-term trends in corporate Japanese earnings, we’ve seen Japanese GDP declining for 20-years but seen Japanese earnings actually do quite well and in line with U.S. earnings growth. So large cap Japan is not tied to the Japanese economy—it is more about being tied to global economic growth.”
So if you think the global economy will do well and if you think the Japanese yen will weaken, then Japan is a buy. Based on what EPFR Global data suggests, last week, everyone was thinking the same thing.