Japanese 10,000 yen and U.S. 100 dollar banknotes are arranged for a photograph in Tokyo, Japan, on Monday, June 20, 2016. Japanese shares fell, with the Topix index dropping for the first time in three days, as the yen rose ahead of the U.K. decision on European Union membership and investors awaited testimony from Federal Reserve Chair Janet Yellen. Photographer: Tomohiro Ohsumi/Bloomberg
© Bloomberg

The Japanese carry trade is taking on a whole new meaning for equity investors. For years, the yen revolved around borrowing or selling short Japanese securities, to take advantage of the reliably low yields and weak currency, and parking somewhere else where there was a higher yield.

Now, Japanese equities are yielding more than US equities, and they are attracting attention from those hunting for yield.

The yield on the Topix stock index overtook that of the S&P 500 in June. The yields on both remain very low, at 2.31 and 2.21 per cent respectively, compared to an average 3.66 per cent yield for stock markets outside the US and Japan, according to MSCI, but it still raises its attractions for US investors.

Further, “quality income” investing — the conservative strategy of buying companies with strong balance sheets and consistent profits that reliably pay an income — is working well in Japan.

According to Société Générale, “quality income” stocks in Japan have comfortably beaten the main Japanese index since the crisis, even as their yield has increased. Thanks to the longstanding corporate Japanese habit of sitting on cash, those dividends remain well protected. This is an unusual combination, and suggests Japan is worth searching for income opportunities.

There is also good reason to hope for continued increases. Corporate governance reforms, part of the largely underwhelming “third arrow” of the government’s Abenomics reform package, are having an effect. According to Activist Insight of London, 13 Japanese companies had been subject to activist demands by the end of July this year. In none of the three preceding years had this number exceeded eight. Smaller companies are the main focus, with investors attacking their balance sheets, rather than trying to force mergers and acquisitions.

With the government itself taking a more active role — through the national pension fund, and through the Bank of Japan’s growing holdings of exchange traded funds — cash payouts are increasing. Total money spent on buying back stock had almost reached last year’s total by the beginning of June, according to Nicholas Smith of CLSA in Tokyo.

Mr Smith, like Société Générale, suggests looking at “equity income” plays. With cash flows rising, and company needs for cash limited, he suggests that the consensus expectation that dividends per share will rise 7.5 per cent over the next year is reasonable.

The other argument in favour of looking for value in Japan is that sentiment has turned so drastically against it. In the wake of the Bank of Japan’s very poorly received announcement of negative interest rates, in January, the Nikkei 225 sank into a bear market. While it has recovered somewhat since then, and has even set a high for the year in dollar terms, sentiment remains very negative. Last month, the outflow to international securities by Japanese investors was the greatest on record, according to Jesper Koll, head of WisdomTree’s operations in Japan. For contrarians, this looks like an interesting opportunity.

Finally, months of internal political wrangling appear to have been resolved in favour of attempting a true fiscal stimulus. The long-term economic wisdom of this can be debated, of course. In the short term, it should be good for stocks. Any further signs of recovering export orders from China would also aid the case for Japan.

The biggest argument against Japan for international investors is, as ever, the currency. The yen has shot up this year since markets refused to believe that the Bank of Japan could go through with cutting rates further into negative territory. That has forced Japanese corporate profits down.

The Japanese authorities are evidently uncomfortable with a yen at its current levels. If the US Federal Reserve were to raise rates, not currently expected by investors, the fall for the yen should be dramatic.

And, as the Japanese market has long been driven by flows from international investors, who have treated Japan’s stock market as though the country is one large exporter, the yen and the Japanese stock market tend to be strongly inversely correlated. A weaker yen means stronger stocks.

So if any catalyst will help Japanese stocks recover, it would be a weakening yen — which would hurt international investors’ return. For those prepared to go stockpicking, the capital goods sector (particularly driven by exports), might be an answer. Domestically-focused smaller companies might also repay a hunt for value and well-supported yield.

For those looking for a more passive exposure, the answer lies in hedging the yen, and the exchange-traded fund industry handily has exactly the necessary products.

Currency-hedged ETFs have had a disastrous year in Japan, as both the currency and the equity bet have gone wrong. At this point, with Japan showing genuine value and needing a lower currency, they begin to look attractive again.


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