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Thursday, 17 April 2014

Shunning Japan gets riskier

After 23 years of being the smelly wet dog of global markets Japan may be at a turning point.

James Saft, Reuters Columnist

With many massively, and understandably, short on Japan, the possibility that new policies actually work, or fail memorably, means investors are carrying considerable, and growing, risk. Now might be a prudent time to move closer to a benchmark allocation, which for most of us means putting money back in Japan.

A set of radical new fiscal and monetary policies being pushed by newly-minted Prime Minister Shinzo Abe might finally succeed in bringing inflation and growth back to Japan, but also could easily end in a financing or banking crisis.

Abe has advocated “unlimited” easing by the Bank of Japan, while at the same time going so far as to lay plans for the government to buy and lease back plants to troubled firms as a means of support and to spur capital investment.

Abe also advocates a weaker yen to make Japanese exporters more competitive. Global markets think he means business, driving down the yen’s value against the dollar by more than ten percent since mid-November, when his victory in elections first seemed secure.

If you are 20% underweight in a market that outperforms the rest of the world by 20 percentage points you are going to have some explaining to do to your clients.

That has been great for Japan’s exporter-heavy stock market, which has risen almost 20% since mid-November and 23%in 2012, its best year in seven.

Here is the key point to grasp: whether Abe is successful in rescuing Japan almost doesn’t matter. The radical new policies raise the chances of a big move in Japanese equities up or down, making the risks of being short or long greater.

If you can see the future, go ahead and go all-in or all-out. For the rest of us, it is probably a good time to lighten up our bets.

And our bets are almost certainly mostly one way. You are probably seriously underweight Japan, and let’s face it, you have had plenty of reason to be short.

Over the past year global fund managers have made their biggest negative bet an underweight on Japan shares, according to a survey by Merrill Lynch. And while Japan shares comprise 15 percent of global equity capitalization, individual investors too tend to be underweight, in part because they are simply under-diversified internationally, but also because Japan has appeared to be such a basket case.

Clever or lucky?

So, whether you are clever or just lucky being light on Japan has worked out brilliantly, as it has been a toxic mixture of volatile and weak. After peaking just below 39,000 at the end of the bubble year of 1989 – yes 23 years ago – the Nikkei 225 index has been on a grinding trip lower, shedding investors as it fell, leaving it below 9,000 as recently as November.

Besides suffering from an aging population and sclerotic economy at home, Japan has really suffered since 2009 as an export-oriented economy with an overvalued currency, with the yen supported by safe-haven flows. (safe-haven?)

Abe’s mix of policy is remarkable, both in its boldness and in the risks it carries. He has pressed the BOJ to double its inflation target to 2.0 percent and to greatly expand its program of buying up government bonds. He has threatened to push through legislation impairing BOJ independence, a step he’s unlikely to be forced to take. Abe’s been explicit about wanting a lower yen, with other members of his cabinet shrugging off criticism from trading partners.

The new policy, in essence, is to force the yen lower, supporting exporters. That’s nominally bad for the value of Japanese stocks, which are of course denominated in yen, but a 5.0 or 10.0 ten percent hit to the yen will be far outweighed by the rush of profits if exports pick up.

That could keep the explosive rally of the past couple of months going.

If you are 20% underweight in a market that outperforms the rest of the world by 20 percentage points you are going to have some explaining to do to your clients.

As well, looked at on a price-to-sales basis Japanese shares cost only a third of the U.S. peers, making them the cheapest in the developed world. But Tokyo stocks have been cheap for two decades, making the Nikkei the place where value investors go to die.

The downside is that, while the Japanese people are rich, its government is deeply in hock, with debt about 240 percent of gross domestic product, dwarfing that of the United States. There is a significant risk that Japanese bondholders sell up if Abe is actually successful in fanning even a little bit of inflation. That could lead to a damaging spike in inflation, a financing crisis or a banking crisis, as Japan’s banks, which ultimately the government must insure, own huge amounts of government debt.

Risk truly is two-way, and the chances of a big move seem large.

Putting money back to work, getting closer to a neutral allocation and cutting risk is probably the best play.

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