Prime Minister Shinzo Abe is certain to be re-elected and his policies will be cemented in place. Those policies and the recent massive decline in oil prices make Japan an interesting short-term play. In the long term, however, investors should be very careful indeed.
Abe’s policies consist of three parts: monetary stimulus, in which the Bank of Japan buys unprecedented amounts of government and other bonds; fiscal stimulus, in which Japan’s already large budget deficit is goosed further by extra spending programs; and market reforms. Of these, the third isn’t going anywhere – there is little appetite in the United States for a large-scale “Trans-Pacific Partnership” trade deal and reforms of Japan’s agriculture and retailing sectors come up against powerful entrenched interest groups.
Japan’s central bank’s bond buys were recently increased to 85 trillion yen ($700 billion) annually – relative to the economy, about twice the size of the Fed’s “QE” program at its peak. That helps Japan finance its gigantic budget deficit, which according to The Economist’s survey of forecasters will come in at 8.1% of GDP in 2014 – far larger than that of any comparable country.
Even more dangerous, Japan’s debt is now 240% of GDP. By historical standards, that’s close to a level at which default becomes inevitable.
The Abe plan is to drive down the yen to a level at which exporters provide Japan with such a boost that the economy recovers spontaneously (the yen has already declined from about 80 to the dollar to 118 in the last two years.) In the short term, that makes Japanese exporters very interesting investments.
The hope is that long-term economic growth will rise so much, generating tax revenues, that Japan’s budget deficit will begin to close and the debt will become a less overwhelming percentage of GDP. (Almost all the debt is denominated in yen, so there is no worry that yen devaluation might boost its value.)
There are two problems.
First, the budget deficit can’t be closed because of Japan’s incessant “stimulus” boosts to spending. Japanese public spending has risen steadily from 30% of GDP in 1990 to over 40% now, causing a permanent budget deficit and a huge debt load.
Junichiro Koizumi, prime minister from 2001 to 2006, had the right idea. He cut public spending, reduced the deficit and tried to privatize the postal savings bank (the biggest investor in government debt). If he had lasted as long as Margaret Thatcher (11½ years) or even two full U.S. presidential terms, he might have sorted out the problem; unfortunately, he was out of office within five years.
Second, Japan’s demographics make it difficult for the country to grow. More people are retiring, year by year, than enter the workforce and the dependency ratio climbs steadily. Thus, the chance of long-term success is low and a crash is almost inevitable, probably around 2016-17.
Until that happens, there is money to be made from economic expansion, especially in Japan’s export sectors. Some possible winners are as follows:
-Toyota Motor (NYSE: TM): The auto giant is Japan’s largest exporter, though it also manufactures in many other countries including the United States. It is one of the principal beneficiaries both of a weak yen and an expanding domestic Japanese economy. The shares trade at 11 times prospective 2015 earnings with a dividend yield of 2.5% – the company intends to maintain a dividend payout ratio of 30% of earnings, which suggests dividend increases may flow as profit margins widen with the weaker yen.
-Nintendo Inc. (OTC: NTDOY): The video game maker appears to be turning the corner in its product lifecycle, with the installed base of its Wii U game player up to 7.4 million units, on analyst estimates, and software such as Mario Kart 8 proving very successful. Again a large exporter, its margins will improve with a declining yen. For example, it made $224 million in the third quarter compared with $8 million a year earlier. It’s thus an ideal short-term play for Japan’s current position.
-Hitachi Ltd. (OTC: HTHIY): The information systems, telecoms, power systems and construction machinery giant is another major exporter, selling on a 13.2 historic P/E ratio with a yield of 1.3%. With earnings nearly tripling to $850 million in the six months ending in September, the company has raised its earnings forecast for the full year to March 2015, as the weaker yen is boosting margins.
-iShares MSCI Japan Small-cap Fund (NYSE: SCJ): This fund gives you exposure to the small-cap sector in Japan, which you can’t practically buy directly, generally offering more growth but less access to the export sector than the big companies. It has a yield of 2.2% and an expense ratio of 0.48%.
In terms of investment strategy, we can expect good news and an expanding Japanese economy for at least the first half of 2015, after which the picture gets cloudier. So these positions should be taken with both trailing price stops and a time stop of June 30.
This article is brought to you courtesy of Martin Hutchinson from Wyatt Research.