by Ivan Martchev | December 26, 2012 11:23 am
After a series of false dawns over the past 20 years — both political and economic — Japan is again making headlines with the return to power in December of the Liberal Democratic party led by former Prime Minster Shinzo Abe[1]. And despite election promises, it will be very difficult for anything to significantly change in Japan, given the intensifying structural issues that suggest a coming sovereign debt crisis similar to what we see in Europe today.
Napoleon Bonaparte famously said[2] that “if you wish to be a success in the world, promise everything, deliver nothing.” Taking this to heart, Abe promised a lot in his election campaign, most notably to focus on a revised monetary policy aimed at pulling Japan out of the fourth economic recession it has experienced in 12 years.
Shortly after his victory, Abe called on the Bank of Japan to see the election results as a reflection of the people’s will, clarifying that after the formation of his government, he’ll instruct his ministers to double the central bank’s inflation target to 2%[3]. Can he deliver?
Fiscal matters in Japan have gotten so bad that it very well may be too late to turn things around. The government budget deficit[4] stands at 9.7% at last count, similar to that of the U.S. at 8.7%. But the Japanese government debt[5] burden is in a league of its own. At 211.7% government debt to GDP[6] at the end of 2011, the Japanese are making the dirtiest of the PIIGS — Greece[7] — seem frugal.
With Japan’s shrinking and aging population, government revenues are likely to keep feeling pressure while spending is likely to keep rising. Tokyo has been trying to get the economy out of its 20-year malaise with a surge in Keynesian-style spending[8], but its resources aren’t unlimited. At 0.77%, 10-year Japanese government bond yields[9] allow for such rampant deficit spending, but how will the government fund Abe’s promises if investors refuse to roll over its debt?
The Japanese are the original inventors of quantitative easing, yet since 1998, the Bank of Japan has had no success in reversing rampant deflation[10] and economic stagnation, resulting from the burst credit bubble in 1990 and the dysfunctional banking system saddled with nonperforming loans, as well as cash hoarding by individuals and corporations alike.
Then there’s the shrinking Japanese population, a process reversible with a lax immigration policy similar to Canada’s, which allows for the relatively easy admission of qualified foreign nationals. Yet the Japanese public views lax immigration as unpalatable.
My guess is there will be a false-dawn market reaction that celebrates the introduction of reforms by newly elected former Prime Minister Abe that may last for quite some time, similar to other such rallies.
The Nikkei 225 Composite benchmark index[11] has spent most of the past 20 years between 10,000 and 20,000 with a few of stabs outside that range. Financial companies are the most exposed to Japan’s structural issues, and they’re likely to rally the most, similar to previous such hope-based rallies.
The only dedicated, integrated securities firm that has listed ADRs in the U.S. is Nomura (NYSE:NMR[12]), which trades at 0.67 times book value. The other beneficiaries of Japanese reflation are the banks — Mitsubishi UFJ Financial Group (NYSE:MTU[13]) and Mizuho Financial Group (NYSE:MFG[14]) — which also trade at similar price-to-book multiples of 0.54 and 0.65, respectively. Such valuations are extreme, yet the length and depth of Japan’s stagnation — now in its third decade — have made institutional and individual investors understandably skeptical.
As Abe spends money he doesn’t have to deliver his monetary reflation, the question of a government bond market rout similar to what’s happened in Europe becomes even more relevant. At present, the International Monetary Fund estimates Japan’s government debt to GDP[15] ratio to reach 256.6% by 2017. Ten-year JGB yields cannot stay at 0.77%[16] if inflation goes to 2%, turning the Abe reflation push into the ultimate kamikaze maneuver because it notably increases the government’s interest rate burden. This may ultimately create large losses for Japanese financials — the holders of JGBs.
In addition to financials, small-caps tend to benefit disproportionately from the type of economic reflation Abe is targeting. While the few ADRs of small-caps are probably not the way to go for U.S. investors, plenty of diversified exchange-traded funds offer access[17] to this market sector.
Some ETFs worth investigating here are the iShares MSCI Japan Small Cap Index Fund (NYSE:SCJ[18]), which tracks the MSCI Japan Small Cap Index with 700 securities in its portfolio; the WisdomTree Japan Small Cap Dividend Fund (NYSE:DFJ[19]), which gives the biggest weights to small-caps that pay the biggest dividends; and the SPDR Russell/Nomura Small Cap Japan ETF (NYSE:JSC[20]), which is the broadest fund, with more than 1,000 holdings.
While I’m rather skeptical about the ultimate outcome of Abe’s efforts, I realize that if he does more than the previous government, the stock market would celebrate it because investors are simply worn out by Japan’s ongoing stagnation. How ultimately successful he’ll be remains to be seen.
Ivan Martchev is a research consultant with institutional money manager Navellier & Associates. The opinions expressed are his own. Navellier & Associates holds positions in Mizuho Financial Group and the WisdomTree Japan Small Cap Dividend Fund for its clients. This is neither a recommendation to buy nor sell the stocks mentioned in this article. Investors should consult their financial adviser prior to making any decision to buy or sell the aforementioned securities. Investing in non-U.S. securities including ADRs involves significant risks, such as fluctuation of exchange rates, that may have adverse effects on the value of the security. Securities of some foreign companies may be less liquid and prices more volatile. Information regarding securities of non-U.S. issuers may be limited.
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