At the end of 2012, many investors and market commentators declared Japan's stock market as the one to watch. After years of devastating deflation, the country's prime minister was prepared to initiate an aggressive monetary stimulus programme to create jobs, pull the country out of its deflationary trap, and devalue the yen in an effort to revive the long-stagnant economy. The news sent stocks soaring, with the Nikkei 225 Index up 19% in the first quarter of 2013 (by comparison, the FTSE 100 Index gained about 9% in this year's first quarter). But the Japanese stock market took a dive in late May, dropping from a high of 15,381 on May 21 to 12,686 on June 14, a loss of 17.5% in less than a month. Although the market has recovered a bit, gaining 9.8% from the June 14 low to the Aug. 23 close, many investors were shocked by the pace at which the market sold off. Despite these setbacks, some pundits and fund managers are still pounding the table on the Japanese recovery story, saying the May drop-off was simply a market correction after a relatively strong run-up since late 2012. On the other hand, sceptics abound.
A Complicated Story
The believers in Japan's recovery story cite aggressive monetary and fiscal policy measures announced at the end of 2012, when Japan's Prime Minister Shinzo Abe passed a stimulus package aimed at creating jobs and upgrading infrastructure. Also, the Bank of Japan governor announced plans to double the monetary base by the end of 2014 in an effort to reach a 2% inflation target. The intended effects of the effort are to weaken the yen, raise asset prices, and increase spending.
Supporting the recovery story are Japan's positive GDP growth numbers. For the first-quarter of 2013, GDP grew at an annualised rate of 3.5%. Preliminary data suggests that second-quarter growth was slower at 2.6%, a disappointing number relative to expectations, but a decent indicator of continuing strength. What's more, in June, Abe announced a "third arrow" in Japan's recovery plan, which included some measures aimed at boosting long-term growth prospects and pushing the economy forward. But many found the plan to be lacking as it failed to address concerns over employment, agriculture, and health care.
While recent GDP growth is encouraging, some say a steep rise in exports suggests that the deflating yen and stock-market run-up may be inflating growth numbers—particularly as business investment remains stagnant, though private consumption has been increasing. Abe also plans to raise sales taxes next spring to 8% from 5%, with an eventual increase to 10% by the fall of 2015. Many worry that raising taxes will hurt a recovering economy. Another recovery drag is Japan's aging population and massive 200% debt/GDP ratio. These issues likely will weigh on Japan's growth in the years to come.
As with any investment story, there are two sides, and the answer is often unclear. Investors in the Japanese recovery story should consider investing through funds—either OEICs and unit trusts, closed-end funds or exchange-traded funds.
Currency Issues
I’ve heard several debates recently about whether Japanese fund managers should hedge the currency in their portfolios. Granted, a lack of hedging leaves the investor vulnerable to a depreciating yen. In Japan, this is particularly relevant because deflating the yen is one goal of Japan’s policy efforts. But this doesn’t necessarily mean bad news for investors. For example, Nicholas Weindling, manager of JPMorgan Japanese (JFJ) is avoiding Japanese exporters for this very reason; instead he favours stocks geared to the local trade.
Fund Specifics
The standout investment trust performer in the Japanese category is the Silver-rated Baillie Gifford Japan (BGFD), run by Sarah Whitley since early 1991. Whitley has amassed an impressive track record, managing to make money for shareholders in what has oft been a sideways-moving market, with gearing deployed well. Given the rally in the Japanese market this year, it’s of little surprise to see the fund has moved to trading at a premium to its NAV.
Baillie Gifford also leads the way when looking at the Japanese small-cap funds. BG Shin Nippon (BGS) has powered ahead in both up and down markets, although it hasn’t worked out well every time—2008 was a case in point. But year-to-date in 2013, the fund is up some 48% against the average peer’s gain of 32%. Once again, it’s a fund that’s now trading at a premium to its NAV.
Fees
While Japanese investment trusts aren’t outright cheap, they offer a definite cost advantage relative to their OEIC peers, although an ETF is cheaper. But the disadvantage of buying a Japanese ETF is that you can’t tilt the portfolio away from troubled areas such as the exporters, given the prevailing macro environment. So there’s a strong case to be made for active management in Japanese equities. It may be bumpy, but with the right manager it can prove to be worth the ride.
For a list of mutual funds providing exposure to Japan Equity, click here.
For a list of investment trusts providing exposure to Japan Equity, click here.
For a list of ETFs providing exposure to Japan Equity, click here.
Morningstar UK director of closed-end fund research, Jackie Beard, contributed to this article.
