The Japanese economy continues to struggle with growth and inflation even as Japanese stocks are at 19-year highs. Some observers say that discrepancy puts the market-crushing gains this year for exchange-traded funds like the iShares MSCI Japan ETF (EWJ) and the WisdomTree Japan Hedged Equity Fund (DXJ) at risk.
They needn’t worry.
In a version of rinse, wash, repeat, Japan’s economy continued its disappointing performance in May. True, there were some bright spots, but the main takeaway is that try as it might, Japan can’t break the stranglehold of two decades of deflation.
Indeed, even amid extraordinary macroeconomic and monetary policy, inflation remains well-below target and the economy probably contracted in the spring.
It shouldn’t be this way. The yen is getting buried by the strong dollar, which boosts exports. The Bank of Japan is committed to purchasing 80 trillion yen worth of assets a year, which is like quantitative easing on steroids. And energy prices have plunged for a country that imports 95% of its energy needs.
Yet core inflation cooled off month-to-month in May, growing just 0.1% from 0.3% in the prior period, and forecasters say the Japanese economy likely slowed or even retracted in the second quarter.
As spooky as that news may be, it’s at time like these that investors in Japanese stocks have to remember that the economy and the equity market are not the same thing.
Just because the EWJ and DXJ are sitting on year-to-date gains of 16% and 20%, respectively, doesn’t mean they’re cruising for a fall. Japanese stocks are not automatically in a bubble against given the economic news.
Bad News Is Good News for Japanese Stocks
Helping the case for Japanese stocks is that, as unimpressive as economic progress has been, it hasn’t been exactly shocking the market to the downside. Some key data even did okay against economists’ projections in the latest period.
True, consumer-price growth slowed month-to-month, down to 0.5% from 0.6% in April but that was better than the 0.4% forecast. Core inflation, which excludes food prices, was up 0.3% year-overy-year, in line with forecasts. Besides, it’s not like anyone investing in Japanese stocks expects inflation to hit the central bank’s 2% target anytime soon.
On the plus side, while the huge drop in oil prices isn’t helping in Japan’s goal of higher inflation, the related savings have been good for consumers. Household spending rose 4.8% in May, which was the first increase in a year.
Markets don’t care about actual figures as much as they do how they come up against forecasts, and in that regard, EWJ, DXJ and Japanese stocks in general have been spared any shocks.
More importantly, anything that points to the economy faltering will likely be good for Japanese stocks, since they will rise on the potential for more stimulus from the Bank of Japan. And that’s what’s driving Japanese stocks more than anything else.
Ultra-easy monetary policy allows Japanese companies to boost earnings by slashing debt expense. It also has them binging on stock buybacks, just like their U.S. counterparts.
Given all that, the triumvirate of earnings growth, buybacks and bad-news-is-good news should support Japanese stocks and the related EWJ and DXJ throughout this year and beyond.
As of this writing, Dan Burrows did not hold a position in any of the aforementioned securities.
