Japaneasing is just the start

The immediate outlook is better but the future is much more complex, writes Barbara Drury.

Japan's muscular new approach to monetary policy has breathed new life into its moribund sharemarket. But analysts warn the market could relapse unless the government also turns its attention to fundamental economic reforms.

"In some ways monetary policy is the easy half of the story, micro-economic reform is the other half," Jacob Mitchell, portfolio manager of Platinum Asset Management's Japan Fund, says.

The Bank of Japan has adopted the US Federal Reserve's approach to monetary policy and promises to do "whatever it takes" to boost economic growth. "It might take more than a couple of years, but what they are doing so far exceeds expectations. In some ways the Bank of Japan has leap-frogged the US Fed," Shane Oliver, AMP Capital chief economist, says.

Japan is committed to purchasing $US75 billion a month in bonds and assets, printing money to do so in a policy known as quantitative easing. By comparison, the US Fed is injecting $US85 billion a month into an economy triple Japan's size. The immediate response has been a plunge in the value of the yen and a leap in share prices.

Japanese shares jumped more than 50 per cent in the six months to March 31, with the Nikkei 225 Index going above 13,500 for the first time in almost six years. But Australian investors lost half of that rise in the currency exchange. Since last October, the yen has weakened from 77 yen to the Aussie dollar to about parity, a depreciation of almost 30 per cent.

Oliver says Japanese shares have gone from extremely cheap in mid-2012 to fair value. While he says the Nikkei could rise a further 10 per cent this year, he thinks the best gains may be behind us. "What has happened in Japan is quite profound. More depreciation of the yen will mean more rises in the Japanese sharemarket. Each one yen [fall against the US dollar] boosts Japanese company profits by about one per cent."

Japanese shares currently trade on a forward price-earnings ratio of 13 compared with 16 in the US and 13.5 in Europe. Mitchell agrees that the market is not expensive, but says it is due for a period of consolidation and maybe a pull-back in the short term.

Despite the boost a falling yen provides to Japanese exporters, sustainable long-term growth depends on reform of Japan's labour and capital markets. Mitchell says Japanese companies and management need to be more accountable to shareholders, and the mergers and acquisitions market needs shaking up. However, he says the new Abe government is making encouraging noises about the wealth effect of the sharemarket.

Japan has moved in and out of recession over the past 20 years, with the property bubble of the 1990s followed by a decade of price deflation. Not surprisingly, Japanese households are wary of investing in property and shares, preferring cash and bonds.

Mitchell thinks the next big leg-up in Japanese stocks will come when local households and pension funds discover they can get inflation protection with a 3.5 per cent dividend yield on quality shares compared with bond yields of close to zero.

For Australian investors, any response to events in Japan is complicated by the historically high dollar. The general consensus is that the Australian dollar will stay higher for longer than previously expected and the Japanese yen will continue to weaken.

Commonwealth Bank chief currency strategist Richard Grace thinks the Aussie dollar will stay strong during this year and probably weaken in 2015. Australian shares won't be immune to the depreciation of the yen, which will make life even tougher for local car makers and our inbound tourism industry. However, a stronger Japanese economy could generate more demand for Australian resources.

"Japan is our second-largest trading partner," Oliver says. "Overall I would rather have a strong Japan than a weaker one, but it does make life a bit tougher for Australia."



How to invest

Opportunities are limited for Australians who want to invest in the Japanese market.

The iShares MSCI Japan exchange-traded fund (ETF) offers exposure to the broad Japanese market index, while Platinum's Japan Fund and BT's Japanese Share Fund are active stock pickers.

The Platinum fund is the only option actively hedged to neutralise the currency effects for local investors.

Recent returns from the three funds show the impact of hedging at a time when the Australian dollar has been rising strongly against the yen. In the year to March 31, Platinum's hedged Japan Fund returned 20 per cent. By comparison, BT's unhedged fund rose just 8 per cent and the iShares unhedged ETF rose 7.5 per cent in line with the MSCI Index in Australian dollar terms.

Of course, if the Australian dollar were to fall against the yen, an unhedged fund would outperform.

While timing entry and exit points into single-country markets is risky, Shane Oliver says international shares will benefit generally from Japan's reflation. "If you don't want the currency risk, buy an international share fund in a hedged version," Oliver says.