Should You Revisit Japanese Stocks?

Should You Revisit Japanese Stocks?
Jonathan Hobbs, CFA

over 1 year ago5 mins

  • Japanese stocks have had a rocky few decades, but they’ve been holding up better than many of their Western counterparts for most of this year.

  • Japan’s relatively mild inflation, negative interest rates, discounted stocks, and improved corporate governance are good reasons to consider Japan ETFs.

  • But you should understand the risks: inflation and interest rates could move higher, and the yen could get stronger. And with Japan’s older population, economic output could slow down.

Japanese stocks have had a rocky few decades, but they’ve been holding up better than many of their Western counterparts for most of this year.

Japan’s relatively mild inflation, negative interest rates, discounted stocks, and improved corporate governance are good reasons to consider Japan ETFs.

But you should understand the risks: inflation and interest rates could move higher, and the yen could get stronger. And with Japan’s older population, economic output could slow down.

Mentioned in story

Like most major stock indexes, Japan’s Nikkei 225 has had a tough run of it this year, falling around 9% since January. But the S&P 500 has dropped more than twice that over the same period, and there are a host of reasons that this outperformance could be set to continue.

Why might Japanese stocks be poised to rally?

1. Japanese profits are outpacing American profits.

Since 2010, Japanese stocks’ earnings per share (orange line) has grown faster than US stocks’ (blue line). In other words, Japanese companies have been delivering more and more value to their shareholders than their US rivals. Just be aware that it’s been a bumpier ride for Japanese company earnings more recently, and they’ve unraveled a fair bit.

Earnings per share growth (trailing) of companies in the S&P 500 and the Nikkei 225. Data from Bloomberg.
Earnings per share growth (trailing) of companies in the S&P 500 and the Nikkei 225. Data from Bloomberg.

2. Japanese stocks are slightly cheaper than US stocks.

The price-to-earnings ratio of the Nikkei is 18.9 right now, which is just below the S&P 500’s ratio of 19.1. In other words, the market sees the Nikkei as slightly cheaper – meaning it costs investors less money to get the same amount of earnings.

3. Japanese inflation is still low.

Buying into Japan could be a chance to invest in a country whose inflation rate isn’t going through the roof. Japan’s inflation rate is just 2.5% right now, which is well below rates in the US (9.1%), Europe (8.6%), and the UK (9.1%). And with inflation still at acceptable levels, the BoJ is still stimulating the economy – with interest rates at negative 0.1%. Now, that might change if inflation ticks up. But in a world of rising interest rates, Japan is doing something different (at least for now).

4. There’s a lot of liquidity in the Japanese market.

The Bank of Japan (BoJ) has injected massive liquidity into the economy through quantitative easing (QE), buying the country’s government bonds and even its stocks to jump start economic demand. This also had the effect of depreciating the value of the yen, which made Japanese company exports cheaper, which helped boost corporate profit margins. It also has meant cheap borrowing rates for Japanese companies, so they could take on more projects and boost shareholder returns.

5. Japan has improved its corporate governance.

Japanese companies have improved their corporate governance over the years, making their management styles more aligned with shareholder interests. This involved things like creating bigger roles for independent board directors, addressing sustainability issues, and introducing restricted stock compensation packages for executives to give them more skin in the game.

What are the risks to Japanese stocks?

1. The yen could hurt prices.

In the past, there’s been an inverse relationship between the strength of the yen and Japanese stocks: when the former gets weaker against the dollar (exchange rate shown in gray), the latter have tended to rally (Nikkei in blue). But when the yen gets stronger, the opposite has happened. The general perception here is that cheaper exports are good for Japanese stock prices. It’s not an exact science, mind you, and the relationship doesn’t always hold.

Japanese yen priced in US dollars vs the Nikkei 225 index. From TradingView.
Japanese yen priced in US dollars vs the Nikkei 225 index. From TradingView.

Of course, the yen’s been falling fast this year against the US dollar, which is benefiting from the Federal Reserve’s most aggressive rate hiking campaign in decades. Higher interest rates, after all, make the dollar more attractive to international savers and investors. And while the yen does look weak technically, the BoJ could reverse course and raise interest rates if inflation starts to balloon higher – that would likely set off a narrative for FX traders to buy back into the yen and boost its value.

2. Japan has the oldest population in the developed world.

Japan has a median age of 48.6 years, and has fewer people under 20 years old than all but Hong Kong and Singapore. So unless the country can attract more foreign workers, its economy – and by extension, its companies – could see declining output over time compared to other countries. On the flip side, this could arguably be good for Japanese stock prices, as slower growth could spur even more extreme QE measures by the BoJ.

3. National debt is really high.

Japan might be the third-largest economy in the world, but its national debt is high – almost three times its gross domestic product. Combine that with aging demographics, and Japan could have a tough time trying to pay off that burden in the long run.

So what’s the opportunity here?

For my money, spreading investments among different countries is a sensible way to go – both for protection and the potential to buy into a new long-term opportunity. If you’re looking to add Japan to that mix, there are a few ETF options to choose from.

If you’re after a spread of larger and mid-sized Japanese stocks, look into the iShares MSCI Japan ETF (EWJ, expense ratio: 0.50%) or the Franklin FTSE Japan ETF (FLJP, 0.09%). If smaller companies are more your style, check out the WisdomTree Japan SmallCap Dividend ETF (DFJ, 0.58%). Keep in mind that these ETFs are not currency hedged. So if the yen becomes even weaker, that would reduce returns to foreign investors. On the other hand, if the yen strengthens, that’ll boost returns to foreign investors.

If you’re looking to cut out those exchange rate effects altogether, opt for a currency-hedged ETF like the WisdomTree Japan Hedged Hedged ETF (DXJ, 0.48%) or the XTrackers MSCI Japan Hedged Equity ETF (DBJP, 0.46%).

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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