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Land of the rising Yen

Investments don’t always make sense.  Factors impacting on asset classes are wide ranging and their effect convoluted.

It is often hard to fathom the sensitivity of an investment to any single factor.  In the current environment where central bank policy action and rhetoric hold so much sway, economic indicators that would normally be viewed as poor are sometimes seen as a positive by markets and vice versa.  In some instances, even in hindsight, it is sometimes difficult to fully understand changes in asset prices and currencies. 

The world’s 3rd largest economy has had a trend of low growth and low inflation/deflation for some time.  Shinzo Abe was re-elected in December 2012 and the phrase ‘Abenomics’ followed soon after.  The three arrows of Prime Minister Abe’s strategy; fiscal, structural and monetary, have had varying degrees of success in stimulating growth and inflation. 

The first big change saw a reshuffle in the Bank of Japan (the BOJ), a change of rhetoric and a willingness to loosen monetary policy. Earlier in 2012 the Yen was trading at less than 80 to the Dollar, just 5 years earlier it was trading at over 120 Yen to the Dollar.  Despite businesses adapting to the stronger Yen, many Japanese companies were unprofitable at 80 dollars.  By the end of 2013 the Yen was trading at over 100 to the Dollar, company earnings were improving and sentiment was riding high.

Initially after Abe’s election, Japan loosened the fiscal purse strings.  Then in 2014 the decision to implement a consumption tax rise (similar to VAT), and failure to reduce other taxes or increase spending, has led to fiscal tightening and some argue that what was another arrow is now off course.

Arrow three was always going to be the slowest out of the quiver, with structural reforms expected to be the longest and most difficult to implement.  To many observers this last arrow has not been loosed or it has been lost in flight, but there is some indication to suggest it is perhaps helping in the workplace.

The demographic breakdown of Japan is very weak, an ageing and declining population becoming more dependent on the state.  However, since 2012 the number of women in the workplace has increased and now a greater proportion of women in Japan work than in the US. The previous decline of those aged 15-64 in work has now stabilised.

However, the most recent Tankan survey which reflects business conditions, indicates lower confidence amongst Japanese businesses.  Large manufacturer sentiment is at its weakest since 2013, before the BOJ introduced its Quantitative Easing (QE).  This is probably a reflection on global growth expectations and exchange rates.

The Yen is now as strong as it was in October 2014, before the BOJ doubled its already impressive QE programme.  This has largely happened since the introduction of negative rates by the BOJ in February. 

Cutting rates is normally understood to weaken the currency but the Yen did the opposite.  At 110 Yen to the Dollar it is considerably weaker than it was in 2012 though.  The problem the Yen has faced isn’t necessarily just the action taken by the BOJ but the timing.  China and the US, both major trading partners with Japan, have seen their currencies weaken and the Yen (still seen as a safe haven currency) has seen inflows of capital as we have moved into a global “risk off” phase.   

Japanese equities are highly correlated to the Yen. The chart below shows just how equities tend to fall on Yen strength and rise on Yen weakness.  The light blue line shows how a sterling investor in Japanese equities would have fared over the past five years or so:

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While we remain cognisant of macro factors when investing, it is important to remain focused on the underlying reason for investment.  Japan looks more attractive than other developed markets in terms of key metrics such as Price to Earnings (PE), forward PE, Price to Book and Price to Cash flow.  Although earnings growth which had nearly reached 50% pa has reduced to about 7% (they have actually contracted over the past 6 months), profits have been more resilient than other developed markets.

The performance of Japanese equity has been disappointing but the underlying fundamentals still lead us to a positive outlook.  At current levels any reversal in sentiment towards risk assets and global growth could see the Yen weaken and be the catalyst for Japanese equities.