Kristina Hooper, CFP, CAIA, CIMA, ChFC, is US head of investment and client strategies for Allianz Global Investors. She has a B.A. from Wellesley College, a J.D. from Pace Law and an M.B.A. in finance from NYU, where she was a teaching fellow in macroeconomics.
US stocks finished higher last week as investors reacted positively to the worse-than-expected manufacturing report and the May jobs report—which, while better than expected in terms of non-farm payrolls, reflected an increase in the unemployment rate. While at first glance a drop in manufacturing and a rise in unemployment might appear to be bad news, both gave investors hope that a tapering-off of quantitative easing (QE) is not imminent. Indeed, while investors were buying US stocks, they also sold off Treasuries, pushing up yields.
Yet even as investors reacted positively to last week's US economic data, Japanese stocks briefly dipped into bear territory—defined as a 20% drop from the high point—in response to Japanese Prime Minister Shinzo Abe's "three-arrow" economic growth plan.
Japanese Investors Dodging Abe's Arrows
The first of these arrows has been well-received by investors since November 2012, when speculation began that Abe would be elected prime minister and aggressively pursue easing. But it's the second and third that have recently been met with skepticism because of their lack of specificity:
- Monetary easing. The Bank of Japan (BOJ) will increase asset purchases over the next two years and encourage more bank lending.
- Fiscal stimulus. Japan's government will fund $50 billion in public-works projects and implement a $100-billion spending package.
- Economic reform initiatives, including enabling the national pension fund to increase stock purchases, improving corporate governance, etc.
After a steady run-up, Japan's stock market has sold off in recent weeks as yields have risen; last week, it sold off in large part due to uncertainty about Abe's plan. Concerns have generally centered around two key issues. First, the enormous headwind created by Japan's demographics has been causing trepidation in the markets. While there is no easy fix, continued reforms, including easing immigration policies, may help alleviate the problem. Second, markets are worried about an increase in government bond yields, which translates into higher debt-servicing costs.
But as renowned economist and Harvard professor Kenneth Rogoff recently wrote, "If the BOJ were to succeed in raising inflation expectations, long-term interest rates would necessarily have to reflect a correspondingly higher inflation premium. As long as nominal interest rates are rising because of inflation expectations, the increase is part of the solution, not part of the problem." Our estimate is that as long as the 10-year Japanese government bond (JGB) yield does not break the 1.5%-2% range and there are continued signs of the economy recovering—as well as signs of rising inflation, which is not happening yet but hopefully will—Japan's market will come back and the Japanese yen will continue to weaken.
Reasons to Be Constructive on Japan
While we may see continued volatility and near-term price weakness in Japan's stock market, we believe a few factors are working in its favor.
- Mr. Abe's economic growth plan loosens restrictions on national pension funds so they can invest more heavily in equities and reduce their exposure to JGBs.
- Post-selloff, Japanese brokerage firms have reportedly encouraged clients to take advantage of lower prices and buy stocks.
- We've already started seeing investors around the globe view the selloff as a buying opportunity. Of course, Nikkei volatility is near 40%; this is not a surprise given recent market gyrations, but it could represent a near-term obstacle for institutional investors.
It is worth noting that after the markets closed last week, Japan's Government Pension Investment Fund announced that it would increase its weighting in both domestic and foreign stocks while cutting back its exposure to JGBs. Abe also just announced the proposal of tax cuts to encourage companies to increase capital expenditures, which will be decided upon by the government this fall, and plans to introduce legislation aimed at ending regulations that have discouraged corporate research and investment.
Clearly, we are still constructive on Japan and do not believe this is the end of the rally. The market has gone up so much in such a short period of time that it is due for a meaningful correction, which is what we are seeing now. In fact, the increase in Japanese equities is commensurate with prior increases. Considering other periods when Japan's stock market rose appreciably, we believe it is not currently overstretched.
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