By Brian Manby, CFA, Principal Analyst, Research
Last month, I had the privilege of visiting the New York Stock Exchange to hear Japanese Prime Minister Fumio Kishida address investors while I was in town for the United Nations General Assembly. Japanese markets stung interest this year, driven by soaring yen weakness and the Bank of Japan’s (BOJ) commitment to accommodative monetary policy, as other central banks turn increasingly restrictive to combat record inflation.
It was a timely opportunity to hear Prime Minister Kishida’s thoughts on the yen’s 23% fall against the dollar this year and, more importantly, the role of Japan’s central bank and government in supporting it. in the future. Just hours before Kishida’s speech, Japan’s Ministry of Finance (MOF) intervened in the foreign exchange markets for the first time since 1998 to support the currency. Before the intervention, the yen traded around 145 yen per dollar and fluctuated around 141 yen soon after. A few weeks later, he gave up his earnings entirely and is currently approaching ¥150.
2022: a challenge for the yen
The support was a brief respite from prevailing headwinds for the yen, which has been challenged this year as part of the BOJ’s commitment to policy accommodation. Japanese short-term rates remain in negative territory and yield curve control has capped longer-term bond yields. Earlier this week, the BOJ conducted an emergency bond buying operation to keep yields near its policy ceiling.
Yen Bears threaten MOF
But the Prime Minister spoke of another catalyst that forced the MOF to intervene: speculative betting on the yen. Kishida asserted his belief that foreign exchange markets should determine exchange rates, but reiterated that speculation may need to be addressed, especially as it creates excessive volatility.
The Prime Minister is right. According to data from the Commodity Futures Trading Commission (CFTC), non-trading net short positions in yen futures have increased since late summer and have held steady ever since. During this period, the currency weakened by about ¥18 to the dollar.
This marked a reversal from the early summer unwinding of short positions. The most recent contract data remains deeply negative despite the September intervention. Non-commercial yen positions have also remained net short since March 2021.
Short bets kept the pressure on
But regardless of the direction of the yen or the catalysts for its movements, Prime Minister Kishida’s involvement was clear. Japan will continue to intervene appropriately to stabilize the yen in the face of what it perceives as excessive speculation and related volatility.
He is likely hoping that the threat of further intervention in the currency markets could scare off yen bears as well, although a month later the intervention had the opposite effect of stoking more volatility. Speculators continue to test the MOF’s resolve and the BOJ’s policy commitment, with the yen selling further as it nears ¥150.
Equity Implications of Yen Tug of War
Yen weakness has always been a tailwind for equities due to the export orientation of the Japanese economy, which has resulted in a negative medium to long-term correlation between Yen and market returns. scholarship holders.
Rolling 60-month correlation: MSCI Japan and yen returns
This year’s weakness resulted from traders shorting the currency due to the policy divergence between the United States and Japan, which will only widen with the Fed poised to continue raising interest rates while the BOJ remains inactive. This may give yen speculators the confidence to continue challenging the BOJ’s reactionary interventions.
However, we don’t know the frequency or magnitude of further MOF intervention, let alone where it will leave the yen in the short to medium term. Given the uncertainty amid opposing forces tug of war with the yen, we prefer a hedged approach to Japanese equity allocations, particularly with a focus on exporters.
Income diversification is key in weak yen environments
The Japanese equity market already contains a healthy mix of export-oriented companies, but seven of the 11 GICS® sectors still derive more than half of their revenue from Japan.
Geographic exposure of MSCI Japan segment revenues
Part of this is due to the nature of the sectors themselves, but in a weak yen environment for the foreseeable future, it may be beneficial to have an overweight allocation to exporters. The WisdomTree Hedged Japanese Equity Fund (DXJ) allocates to dividend-paying, export-oriented companies that derive less than 80% of their revenue from Japan, resulting in greater revenue diversification relative to the MSCI Japan Index.
Geographic exposure of revenues
By design, DXJ also tends to overweight Japan’s more export-oriented sectors while maintaining an underweight exposure to those more dependent on domestic income. For example, Materials and Consumer Discretionary are more dependent on international income than domestic income and have historically been overweight in DXJ due to its export-focused methodology.
Sector exposure at 09/30/22
Japanese yields offer a premium over bonds
My colleague Jeff Weniger wrote about stock premiums in Japan and how it is now a global outlier. Japanese equities, as represented by the underlying index of DXJ, currently offer an 11.5% yield advantage over 10-year Japanese government bonds (JGBs), due to long-term yields capped by the BOJ’s commitment to controlling the yield curve. The index is currently trading at a price/earnings multiple of less than 9, offering an earnings yield close to 12%.
Earnings yield premium over 10-year domestic bond yield
This illustrates the policy divergence with the US, which has widened over the past 10 years as the ripple effects of Fed policy changes have impacted the bond market. If the relationship were to change going forward, the compression could come from rising bond yields should the BOJ change course, but an 11.5% premium with bond yields currently close to zero is a big opportunity.
DXJ is also 100% currency hedged, completely erasing any fluctuations in the yen-dollar exchange rate, so total returns are determined solely by stock performance. More importantly, it allows investors to avoid amplifying the effects of the ongoing yen tussle in their allocations to Japan.
Important risks related to this article
There are risks associated with investing, including possible loss of capital. Investing abroad involves special risks, such as the risk of loss due to currency fluctuations or political or economic uncertainty. The Fund concentrates its investments in Japan, thereby increasing the impact of events and developments in Japan which may adversely affect performance. Currency investments involve additional special risks, such as credit risk and interest rate fluctuations. Derivative investments can be volatile and may be less liquid than other securities, and more susceptible to the effects of various economic conditions. As this Fund may have a high concentration in certain issuers, the Fund may be adversely affected by changes in such issuers. Due to this Fund’s investment strategy, it may make higher capital gains distributions than other ETFs. Dividends are not guaranteed and a company currently paying dividends may stop paying dividends at any time. Please read the Fund’s prospectus for specific details regarding the Fund’s risk profile.
Brian Manby, CFA, Principal Analyst, Research
Brian Manby joined WisdomTree in October 2018 as an Investment Strategy Analyst. He is responsible for assisting in the creation and analysis of WisdomTree’s model portfolios, as well as helping to support the company’s research efforts. Prior to joining WisdomTree, he worked for FactSet Research Systems, Inc. as a Principal Consultant, where he assisted clients in the creation, maintenance and support of FactSet products in the investment management workflow. Brian earned a BA with a double major in Economics and Political Science from the University of Connecticut in 2016. He holds the Chartered Financial Analyst designation.
Editor’s note: The summary bullet points for this article were chosen by the Seeking Alpha editors.