Japan has experienced a complete turnaround in terms of inflation in the last year, moving from a deflationary environment in 2021 to one of 2.4% year-over-year inflation in April, with more inflation potentially on the horizon. It’s creating an environment of opportunity for investors looking ahead to the end of 2022 and into 2023, with attractive prices potentially proving highly beneficial for Japan’s corporate sector, wrote Jeff Weniger, CFA and head of equity strategy at WisdomTree, along with Kevin Flanagan, head of fixed income strategy at WisdomTree, in their most recent Minds on the Markets paper.
Inflation has seen the Japanese yen weaken from ¥115 per one U.S. dollar at the beginning of 2022 to its current ¥136 per dollar. With Japanese inflation still substantially lower than U.S. inflation, Japan could be aligning to be a big competitor not just against American corporations but also Chinese ones as well.
“So what’s happened is because the yen is weakening against everything, suddenly the Japanese are really competitive against the Chinese,” explained Weniger on a recent call with VettaFi. “It sets up a situation in which Japanese corporations have earnings expectations that are lower than S&P 500 earnings expectations, and yet there’s this tailwind behind it.”
That tailwind is the yen’s weakness making Japanese manufacturers and suppliers much more attractive than their Chinese counterparts for international businesses. As supplier contracts begin to expire for 2022, Japan becomes a much more appealing option for the fiscal year 2023 due to its prices being cheaper than those of its Chinese peers. China’s yuan still remains somewhat pegged to the U.S. dollar, and as the dollar strengthens, the yuan is also gaining.
“Plenty of purchasing managers are going to check the math from various bidders and find that the Japanese supplier they rejected in years past is now offering the best pricing,” Weniger and Flanagan wrote.
The Missed Opportunity for U.S. Investors Allocating Globally
In 2021, Japan traded for 14.1x earnings and is forecast for 12.9x earnings for 2022, multiple points lower than the S&P 500’s 2022 P/E estimates of 19.5. Even if Japan does end up underperforming for the year, its less ambitious earnings expectations create a “room for disappointment gap” for investors — for reference, the 2022 consensus for the MSCI Japan Index is 9.8% earnings growth compared to the S&P 500’s 10.7% earnings growth forecast.
Japan is the third-largest economy globally, and yet it remains vastly underrepresented in the MSCI All Country World Index (ACWI), making up just 4% compared to the United States’ 61%. What that translates to is that a vast majority of U.S. investors simply don’t own any meaningfully sized allocations to Japan, despite its potential outlook.
There are challenges ahead for Japan, with Japanese consumers unhappy, as they are accustomed to deflation and strongly dislike the current inflation. Japan also remains almost entirely reliant on foreign oil, grappled with negative GDP growth in the first quarter, and could be in the midst of a recession similar to the U.S.
“In recession or near-recession times, having a newly competitive currency may be what saves a country’s stock market from missing on earnings. Japan is in the driver’s seat, while U.S.-domiciled firms have the proverbial ‘front-wheel drive up an incline’ from the dollar’s relentless strength,” wrote Weniger and Flanagan.
The WisdomTree Japan Hedged Equity Fund (DXJ) offers investment into the Japanese equity market while hedging for currency fluctuations. It’s a pure play on Japanese stocks, as it removes the impact that the yen’s value has while still offering exposure to Japan’s equities. It is a popular choice when the yen is weak relative to the U.S. dollar.
DXJ carries an expense ratio of 0.48%, and top holdings include Toyota Motor Corp at 5.25%, Japan Tobacco Inc. at 4.91%, and Mitsubishi UFJ Financial Group at 4.38%.
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