What Happened in H1 2014?
One of the most popular investment themes coming into 2014 was Hedged Japanese Equity (owning Japanese equities while simultaneously hedging out the risk of the Japanese Yen weakening against the US Dollar). At its core, this theme leaves investors long Japanese equities in US Dollar terms, not Japanese Yen terms. This investment turned in very poor performance for the first half of 2014. By the end of Q1 2014, Japanese equities had sold off rather sharply and the US Dollar had weakened 2.01% versus the Yen. An investor in the Hedged Japan Equity theme would have felt the 2% currency loss as well as the 8.24% loss seen in the MSCI Japan Index during Q1 2014. This 10.25% loss over 3 months helped to “reset” the trade and allowed for a more attractive entry point for the thematic investment.
The underperformance in early 2014 can be attributed to a few factors. The theme was crowded by the end of 2013, and after strong 2013 performance the trade was meaningfully overbought, setting the stage for mean reversion and profit taking. More so, the loss of 2013 momentum coincided with fears of an Emerging Market (“Fragile Five”) currency crisis that escalated in January. These concerns led to broad selling of emerging market investments, strengthening the Japanese Yen as the global carry trade unwound. Furthermore, a 3% sales tax increase in Japan went into effect in April. This led to noise in economic data and uncertainty regarding the medium-term trajectory of the Japanese economy and monetary policy.
We are attracted to the Hedge Japan Equity theme for three primary reasons. First, the explicit policy of the Bank of Japan and Government of Japan is to weaken the Yen, create asset price inflation, and support economic growth. Importantly, the policies had a positive impact during 2013, and more accommodative initiatives are expected in 2014 and beyond. Second, valuations are attractive while fundamentals are strong. Third, near-term equity price momentum is positive and accelerating.
Japan’s monetary accommodation, fiscal policy, and structural reforms have been coined “Abenomics” after Japan’s Prime Minister Shinzo Abe. Abenomics is a three arrowed multi-front attack on the deflation and slow growth that has mired Japan for more than 15 years. The first arrow is monetary accommodation (creating negative real interest rates, expanding the central bank’s balance sheet, and weakening the Yen), the second arrow is fiscal policy (tax cuts), and the third arrow is structural reform (industry de-regulation, increasing women in the workplace and incentivizing investment). Importantly, the Bank of Japan and the Government of Japan are coordinating their attack, a stark contrast to the level of US Congress and Federal Reserve cooperation during the implementation of “Quantitative Easing” in the United States. This “unified front” is crucial, as the BoJ and the Japanese Government need to establish creditability for Abenomics and the associated inflation target of 2%. Japan has an aging and traditionally risk-averse population, so Abenomics needs to be aggressive and persistent to overcome demographic pressures and break long standing expectations for deflation.
The primary objective of Japan’s monetary policy is inflation. Deflation can lead to liquidity traps where cash is horded and growth disappears. Japan’s “lost decade” (or more) is an example of the risks associated with a deflationary spiral. Although short lived (so far), the Bank of Japan has delivered price inflation. In April, prices for all items soared 3.4% from a year earlier, while prices excluding food and energy rose 2.4%. The challenge now is to maintain inflation long enough to change long term inflation expectations.
Inflation, and Yen weakness, allows the Bank of Japan to engineer negative real interest rates (nominal interest rate minus inflation). Negative real interest rates make it expensive to hold cash and low yielding fixed income (like JGBs). This condition creates an incentive for investors and Japanese household to allocate to riskier assets, like equities and real estate. Furthermore, negative real interest rates benefit any business, households, or government institutions that carry a debt as inflation can cover interest expense and even some principal.
Relative to the other central banks, Japan has a more accommodative interest rate policy. Not only is the Bank of Japan’s interest rate lower than other central banks, the rate is expected to stay lower for longer. This relative monetary policy, and interest rate differential between the U.S. and Japan, should drive U.S. Dollar strength versus the Yen.
A weaker Yen should benefit Japanese exporters. Japan’s primary exports have fairly inelastic demand, meaning export prices usually do not need to drop as much as the Yen depreciates, yielding higher profits for exporters.
On June 25th, Japan’s Prime Minister, Shinzo Abe, announced that the government will aim to cut the corporate tax rate to below Germany’s levels. According to Japan’s Finance Ministry, Germany’s effective corporate tax rate was 29.55% as of Jan. 2013, and Abe projected that the final landing spot for the corporate tax rate would be between 20%-29%. The Cabinet approved a plan to start cutting corporate taxes from FY2015, with aim of lowering the level to under 30% in a few years. Japan’s corporate tax rate is currently around 35.6%, and it is estimated that a 5% tax cut will improve TOPIX equity index overall ROE by approximately 60bps.
If structural reforms, the third arrow, are to have large effects, we would expect to see it first in rising forecasts of real future growth and lower long run inflation expectations. If inflation expectations fall at the same time as growth forecasts rise, it would suggest that forecasters expect positive future supply shocks.
Only the tip of the “third arrow” has been revealed, but these initial reforms could have a meaningful impact on growth and consumption. Agriculture reform, even given disappointments, should, on the margin, raise aggregate disposable personal income. This should happen through reducing subsides for inefficiency, and by increasing consolidation of farmland, allowing agricultural households easier access to accumulated illiquid wealth. Also, medical reforms should raise households’ purchasing power, another implicit rise in disposable income. In aggregate, the consumption effects of the announced reforms could be significant.
While monetary and fiscal policy initiatives have been broadly outlined, the structural reform arrow of Abenomics still remains largely undisclosed. It is important that Prime Minister Abe and the Japanese Government use this opportunity to strengthen the creditability of Japan’s inflation target. Prime Minister Abe’s is expected to continue rolling out revamped growth initiatives and reforms to generate new investor enthusiasm. New initiatives could include immigration reform and enticing women into the workforce, two moves that could help Japan overcome an aging population and shrinking workforce.
Enhancing the creditability of the BoJ and Government will help convince Japanese households and the Government Pension Investment Fund (GPIF) to re-allocate to risk assets and away from Japanese Government Bonds. Only 8% of aggregate Japanese household assets (roughly $15Tr) are invested in equities. The Japanese government hopes that the NISA accounts (Nippon Individual Savings Accounts) will draw approximately $250B into the Japanese equity markets, while Nomura Research Institute estimates that it could be as high as $690B. Furthermore, the GPIF raised their target equity allocation from 18% to 26% at the end of 2013, and it is expected that this equity allocation will continue to grow.