The earthquake and tsunami that struck Japan March 11 have devastated the country, and experts are lukewarm about the prospects of investing. Equally important to many investors is the future of the yen carry trade, which became problematic in the aftermath of the devastation. FEMM Contributing Reporter Joe D'Allegro spoke with Clark Li, a partner at Balentine and director of the firm's global investment research; Seth Hurwitz, a senior research consultant at Cambridge Associates; Ronald Frashure, president and ceo of Acadian Asset Management; and Benjamin Segal, managing director and portfolio manager for the global equity team at Neuberger Berman, about the Japan and its ongoing recovery.
FEMM: Given the natural and nuclear disasters that recently struck Japan, should nonprofits invest in the country? If so, how?
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Clark Li |
Li: Yes, even though risk aversion has increased and equities were sold off in the immediate aftermath of the catastrophe. After more than a decade's decline in valuation from their inflated levels of the early 1990s, the Japanese stock market is no longer expensive today, its multiple is roughly in line with the rest of the EAFE index constituents. However, we see key near-term risks that remain unresolved, and an absence of positive momentum means that we remain cautious and still recommend an underweight allocation to this region versus the MSCI EAFE index. Japan accounts for around 20% of the index today. Country ETFs are an effective approach to build the exposure in the Japanese market for those who want a cheap and highly liquid implementation vehicle.
Segal: Japan has some great businesses such as, Jupiter Telecommunications and Nippon Electric Glass, that have prospered despite a weak economy, weak demographics, and an appreciating currency over the past 20 years. Japan remains an important part of the global equity markets; the recent disaster shouldn't change this.
Frashure: We believe the longer-term case for investment in carefully selected Japanese equities is solid, even as the disasters have threatened an already-tenuous economic recovery in the country. Our view is that despite elevated short-term risk in the country, a longer time horizon argues for continued investment in Japan and that, over time, Japanese equities chosen with careful stock selection are likely to yield attractive returns well within the nonprofit investment plan's typical risk tolerance. Even in the shorter term, the Bank of Japan has sent a strong signal that the central bank will provide liquidity to protect the nation's banking system, and the post-disaster landscape opens the door to the possibility of more expansionary policy. This should help spur longer-term growth, and we believe the broad Japanese market will recover fully, as it did after the Kobe quake in January 1995, when the market ended higher within a year of the disaster.
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Seth Hurwitz |
Hurwitz: The decline in the Japanese market has made valuations that already appeared at or near their most attractive level in several decades look even better. Japan's fundamentals have also suffered, at least in the short- to intermediate-term. We think a neutral allocation to Japanese equities relative to global equity market benchmarks is appropriate for most investors, although those with a truly long-term outlook and ability to tolerate short- to intermediate-term underperformance could reasonably justify a modest overweight. Japanese firms remain well positioned to benefit from global growth, particularly if the yen weakens. Investors may find opportunities as well in the hedge fund sector, particularly given the high uncertainties in the market. Another possibility is private assets, which could benefit from reconstruction.
FEMM: How will the damaged nuclear power plants affect Japan's recovery?
Frashure: Nuclear energy generates about 30% of electrical power for Japan. The earthquake and tsunami shut down 10GW out of capacity of 50GW, so 20% of Japan's nuclear capacity was taken offline. Industrial production fell more than 15% from the previous month, half of which came from falling automobile output, which plummeted roughly 50%. Exports overall fell 2.2% year-to-year in March, which marked the first decline in nearly a year and a half. From a longer-term perspective, however, we believe that Japan will rebound strongly because of the likely economic growth associated with the nation's post-disaster reconstruction efforts. Rebuilding the lost stock of residential structures, commercial buildings, infrastructure and capital equipment should cause a surge in Japanese output and demand over the next two to six quarters.
Hurwitz: The situation regarding the damaged nuclear plants in Fukushima remains unresolved, with questions surrounding how much radiation has been released and the short- and long-term effects of such radiation on habitability of parts of the region, production of Japanese firms, and safety of certain food products. The broader impact on Japanese industrial, commercial, and financial activity remains unclear, but the short-term effect on the economy has already been significant. Moreover, power shortages affecting much of Japan, including Tokyo, are expected to last at least through the summer despite various conservation measures being taken. While the rebuilding effort should serve as a boost in the intermediate term, restoring production to pre-crisis levels will be more difficult until the situation surrounding the nuclear power plants is resolved.
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Benjamin Segal |
Segal: Consumers are unlikely to spend extravagantly over the next few months. Moreover, companies in neighboring markets such as Korea, Taiwan and China may be able to capitalize on the disaster to take share from Japanese firms. This is likely to impact negatively the speed of Japan's recovery.
Li: The damage to its nuclear plants remains a key unsettled risk factor for Japan's recovery. First, the effects it has on power shortages--the duration of sustained power outages due to the emergency and subsequent shutdowns of other nuclear plants, as well as the potential continuous radiation threat could cause industrial production to decline and capital expenditure plans to be deferred across the country. Secondly, it could undermine consumer sentiment, affecting many industries, especially in the transportation and traveling sectors. The shocking state of Japan's public finances--its public debt to GDP ratio is the highest in the developed world at over 200%--means that the government's ability to provide stimulus to aid the recovery is more limited than in other countries facing such natural disasters.
FEMM: What sectors of the Japanese market show the most promise?
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Ronald Frashure |
Frashure: Over the longer term, export-oriented companies should benefit from the effects of an expected weakening of the yen against most other currencies. Meanwhile, the Japanese government has announced several emergency measures to minimize economic disruption and to assist with rebuilding effected areas, which will likely have a positive impact on construction, materials, and capital goods companies over the nearer term. The impact on commodities will be mixed. As Japan imports most of its energy supplies, the decrease in nuclear generation must be offset by other sources, most likely natural gas imports. The most immediately hardest-hit sector in the economy was auto manufacturing, and the time frame for its recovery remains uncertain.
Li: From a macro perspective, we continue to believe that the Japanese stock market will provide more promising opportunities than its bonds. The yields of Japanese bonds are dramatically lower than their U.S. counterparts. If U.S. investors demand a similar level of yield from the 10-year Japanese Government Bond (JGB), its yield would have to rise from today's 1.2% to 3.6%. This would cause the 10-year JGB to drop in price by 20%. At a more granular level, China has become Japan's largest trading partner since 2007 and will continue to play an important role as a source of economic growth and corporate profits. We see stocks and sectors exposed to this theme showing the most promise.
FEMM: What is the outlook for the yen carry trade?
Hurwitz: The carry trade rests upon the perception that a low volatility environment exists and will be maintained. This is why the yen carry trade collapsed during the financial crisis and why it may have been taken off in the immediate aftermath of March 11, as the yen strengthened against the dollar. Although worries on the part of Japanese households could lead them to repatriate foreign investments, negatively affecting the carry trade, we believe that factors supporting a continuation of the carry trade may be somewhat stronger. For example, G-7 support for a yen that is not too strong provides some basis for the view that the currency will not be overly volatile--at least in one direction--which could potentially fuel another increase in the yen carry trade.
Li: The dynamic for the yen carry trade is coming back--the G7 nations' coordinated effort on March 18 to stem the yen's strength is one sign of this. Also supporting the carry trade is Japan's low interest rate environment, which is widely expected to extend through 2013 due to the Bank of Japan's clear, "easy" monetary policy stance. As other central banks start their interest rate tightening cycles, a growing number of investors will be enticed again by the carry trade.
Frashure: In the immediate aftermath of the disaster, investor expectations for insurance and reconstruction-related repatriation caused the yen to strengthen and carry was not a driver of currencies. Looking ahead, however, the relative interest rate differential continues to support the yen carry trade as insurance needs moderate, long JPY positions are reset, and the trade balance deteriorates because of an increase in imports.