Japan's rotation has an Aussie twist

May. It is fast approaching that time of the year when the mantra on Wall Street is to sell and go away.

Given the events of the past fortnight – unprecedented intervention by the Bank of Japan, a meltdown in global gold markets, upheaval on commodity markets, tepid growth in the Chinese economy and yet another downgrade on global prospects by the International Monetary Fund – it’s unlikely anyone will stray too far from their trading screens.

Bond yields are at all-time lows. Wall Street is at a record high. Historically, that is a break with the traditional trend – where US treasury yields and equity prices normally are in lockstep – that cannot be maintained.

What in recent times has become the traditional mid-year correction has taken on an added sense of inevitability this year, with equity strategists worldwide focussing on defensive plays. The usual suspects have all been given an airing: utilities, finance, real estate investment trusts.

But those looking to capitalise on recent events increasingly are focussing on Japan and the impact that its recently announced money printing program, in addition to tax changes, will have on its domestic equity market.

A lot has been written about rotations in the past year; out of bonds and into equities, out of commodities and into equities. Now the talk is all about the Great Japan Rotation. In essence, however, it is simply a continuation or another phase of the rotation into equities, now spurred along by a monetary and fiscal bazooka, the extent of which has stunned global investors.

I first highlighted the possibilities of a Japanese equity market revival in mid-January (Japan back on the equities radar screen) when the Nikkei 225 was sitting at 10,800. It is now perched at 13,222. During that same period the Australian dollar has strengthened against the yen, now buying 100 yen as opposed to 95 yen and delivering more buying power to Australians looking to access the Japanese equity market.

With the Australian dollar at record levels, and indications that lower commodity prices will eventually weaken it, this could be a historic opportunity.

The power of “Abenomics”

Some call it Abenomics, after the return of Shinzo Abe as Prime Minister last December. Bank of America has been less subtle and certainly less flattering, with the acronym Asset Bubble Economics.

But the bank is overwhelmingly in favour of a switch into Japanese equities and specifically, Japanese financials, as a strategy to avoid the expected mid-year correction.

“Japanese assets are being deliberately reflated by the authorities. Japan is one of the few regions that unambiguously benefits from inflation and we believe that reflation or inflation is beneficial for Japanese financials,” it noted immediately after the April 4 money printing bombshell.

The foreign rush to Japanese equities has since begun in earnest. Last week, foreign buying – at ¥1.57 trillion – hit its highest levels since the Ministry of Finance began collecting the data in 2005. Since mid-November, foreigners have ploughed ¥8.22 trillion into Japanese equities, helping push the benchmark Nikkei more than 50% higher.

Contrary to expectations, Japanese investors also repatriated money last week after the announcements, to cash in on an expected boom in the equity and property markets. Many commentators forecast the opposite; that Japanese investors would seek higher yields elsewhere such as in Australia.

This isn’t the first time Japan has adopted extreme monetary measures to extract itself from an economic slump. Between 2003 and 2006, the TOPIX index more than doubled in response to Bank of Japan policies.

“Today, Japanese equities are cheaper, yields are higher, and government bond yields are lower than in 2003, so we remain bullish,” says Bank of America Merrill Lynch.

Domestic tax changes

In addition to the huge money printing program, the new government has announced a proposed range of initiatives designed to prompt small investors to allocate a greater portion of their savings into equities. This change has received scant coverage internationally.

The introduction of Individual Savings Accounts from January next year will deliver capital gains and dividend income tax relief for those who commit funds to riskier assets, such as equities. The proposed tax reforms will not cover bonds or deposits.

Japanese households have almost 85% of their investments in cash deposits and insurance/pension reserves, rather than directly in equity markets. The Government Pension Investment Plan similarly holds just 11% of its portfolio in domestic equities.

It is anticipated that the shifting performance on domestic markets could force a reallocation of the portfolio that could see equities exposure rise to 18%. Based on its total investment portfolio of ¥112 trillion yen in December, the GPIP could direct an extra ¥6 trillion into equities.

Opportunities in banking

In 1990, the Tokyo Stock Exchange banking index burst through 1,400. Today it sits just above 150.

Decades of recession and deflation, particularly in real estate, has battered the economy, dented national pride and seriously depleted the credibility of government. Shinzo Abe’s re-election and his radical monetary solution, while considered to be of dubious merit by many economists, is expected to directly lift the Japanese banking sector.

Real two-year interest rates in Japan since 2007 have averaged at about 0.5%, as opposed to minus 1.2% in the US. Ongoing deflation has kept buyers on the sidelines.

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Japanese banks are considered to be a classic recovery play and in the past two months, regional banks – some of the worst affected by the deflation of recent years – have soared. Merrill Lynch cites Bank of Yokohama as a prime example.

Real estate and J-REITs have also been early beneficiaries of the new reflation policy, boosted by expectations that the price slump has ended.

How to invest

With half a dozen major banks and more than 64 regional banks, along with several trust banks, there is no shortage for direct investment in the Japanese banking sector.

Melbourne-based Fortrend Securities specialises in direct offshore trades. There are also a number of exchange-traded funds available to invest in the Japanese banking sector.

Daiwa Asset Management operates a TOPIX bank ETF, which is an open end stock investment fund that reflects the Tokyo Stock Exchange bank index.

On the ASX, iShares runs a MSCI Japan ETF, reflecting the broader Japanese market.

In the property sector, Daiwa operates a listed real estate fund while NEXT has a J-REIT ETF.

There is also a direct opportunity for Australian investors in the form of the Astro Japan Property Trust with a portfolio of office, retail and residential property. Its stock has risen sharply in recent months, from $2.90 at the beginning of the year to more than $3.90 now (see Collected Wisdom).

Ellerston Capital, run by long-time Packer family investment advisor Ashok Jacob, became a substantial shareholder during this period but since has sold down.

Japan’s risk equation

Japan has a long and unenviable history of failure when it comes to reinflating its economy. While it remains the world’s third-biggest economy, during the past two decades its relevance to the global economy has been overtaken by China as successive rescue plans have been mired in corruption and ineptitude.

The latest plan is by far the most ambitious, at least in terms of scale. The Bank of Japan intends to purchase $600 billion in Japanese government bonds and risk assets in each of the next two years, which will double the size of its balance sheet by end 2014 to around 60% of GDP.

But, for the immediate future, an injection of this size can only be positive for equities, particularly when combined with the recent push to break down the corporate cross shareholdings that have dominated Japanese conglomerates.