The Case for Japan, with a Caveat (Koesterich)

While Japan’s stock market has been disappointing investors for more than two decades, it’s currently in the midst of one of its periodic rallies. Stock prices awakened late in 2012, and are now up approximately 20% over the past twelve months.

This has a lot of momentum-oriented investors eying Japan, asking: “Is now a good time to consider taking the plunge?”

My answer is yes, but with an important caveat. While I’m optimistic that Japanese stocks can move higher in coming months, I’d advocate investing in them only if dollar-based investors have the flexibility to hedge the currency effect of a weaker yen (more on that below).

So with that caveat out of the way, here are four reasons why I think Japanese stocks can move higher in the near term:

• They’re cheap. Despite the recent rally, Japan remains one of least expensive markets in the developed world, with Japanese equities still trading at close to book value.
• New fiscal stimulus. Japan’s new Prime Minister Shinzo Abe recently announced a new 10.3 trillion yen stimulus package. While I’m skeptical that this will do much to help Japan’s long-term stagnation (which is more a function of structural rigidities in the economy and a rapidly aging population), the stimulus should boost Japanese growth in the short term.
• An improving global outlook. As Japan is an open economy dependent on exports, Japanese stocks have done best when global growth is improving. While I have modest expectations for global growth in 2013, I do expect to see some improvement in emerging markets, particularly in China. Japanese exporters should benefit from this trend.
• Upcoming monetary stimulus. The Bank of Japan (BOJ) recently announced an inflation target of 2%. In order to reach this new goal, the BOJ will convert its current asset purchase program into an “open-ended scheme”, similar to the Fed’s QE3. The BOJ will buy about 13 trillion yen of assets on a monthly basis, starting in January of 2014. This program will weaken the yen, which is a positive for local stocks, and particularly exporters. This is because a weaker yen makes Japanese companies more competitive in international markets.

It’s this last point, however, that represents the big risk of investing in Japan for dollar-based investors. For them, a weaker yen means that any gains in Japanese stocks will be offset by currency losses. In other words, a depreciating local currency lowers the total return on the investment, as I recently explained in a post on currency considerations for international investing. Without the flexibility to hedge this currency effect, dollar-based investors may wind up giving back a significant portion of their Japanese gains.

Source: Bloomberg

Russ Koesterich, CFA, is the iShares Global Chief Investment Strategist and a regular contributor to the iShares Blog. You can find more of his posts here.

International investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations.