Stick with Japanese stocks

It's been a tough year for the country, but an expanded QE programme and a falling oil price mean investors should stay put, says John Stepek.

Back in March this year, when my colleague Merryn Somerset Webb last wrote about Japan in MoneyWeek, her conclusion was that, while the really easy money might have been made, you should keep holding on.

Ultimately, regardless of what other reforms may or may not materialise, more stockmarket-boosting money printing was coming, so you should make sure you were along for the ride.

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Back then, faith in Abenomics' Prime Minister Shinzo Abe's vows to use money printing, government spending, and labour market and other reforms to revive inflation in Japan was starting to wobble.

In particular, investors were fretting over the impact of a rise in the consumption tax, from 5% to 8%, planned for April. A decision to bump up the sales tax in the late-1990s was blamed by many for stymying any hope of recovery, and the worry was that a repeat might be on the cards.

Those concerns might have been justified. As it turns out, 2014 has been a tough year for Japan, economically speaking. In the first quarter of the year, GDP grew strongly, partly because Japanese consumers were going on a buying spree ahead of the well-flagged rise in the sales tax. In the second quarter, GDP slumped. So all told, the first half of the year was pretty much flat.

More recently, data have been mixed too. Annual inflation (after adjusting for the impact of the sales tax) in September came in at 1.0% the lowest in 11 months. Meanwhile, the ratio of available jobs to applicants fell to 1.09 in other words, there are 109 jobs available for every 100 applicants. That's still a very favourable ratio, but it was the first drop seen since May 2011, according to The Wall Street Journal.

That has clearly bothered the Japanese central bank the Bank of Japan (BoJ) which has been a critical driver of the Abenomics project. Central-bank boss Haruhiko Kuroda has promised to get inflation up to 2% at some point in 2015.

And from an investor's point of view, it's Kuroda's quantitative and qualitative easing (QQE)' campaign, which started in early 2013, that has ultimately been responsible for the Japanese market's stunning comeback since then. With the plunging oil price in particular threatening to derail his 2% goal, there was only one thing for it.

Last Friday, the day after the Federal Reserve had ended its own quantitative-easing (QE) programme (see page 6), the BoJ announced it would massively expand QQE. It will now be buying 80trn ($720bn or so) of Japanese government bonds (JGBs) a year, rather than a mere 50trn or so. The BoJ will also buy longer-dated JGBs.

Currently, the average duration (the time until the bond is paid back) is seven years. Now it will be seven to ten years. The BoJ already owns 25% of outstanding JGBs. At this rate, it could own 50% of them by 2018, notes Andy Mukherjee on BreakingViews.

On top of that, the BoJ also plans to triple its purchases of exchange-traded funds (ETFs) and real-estate investment trusts (Reits). Compared to its purchases of JGBs, the equity money is small beer but even so, as the Financial Times points out, "at this pace, the BoJ is going to become the second-largest holder of Japanese equities within about six months".

And this is coming at a time when the BoJ's balance sheet is already pretty bloated looking, as the chart shows. In short, Japan's money-printing programme is far bigger relative to GDP than any other developed economy.

Perhaps unsurprisingly, this expansion stunned the market, to put it lightly. The yen plunged, dropping to a fresh seven-year low against the US dollar. Meanwhile, the stockmarket soared both the Nikkei and the Topix hit new multi-year highs.

While investors had been expecting some sort of fresh intervention eventually, few had bet on the BoJ acting so soon. And judging by the voting, the BoJ's monetary policy committee wasn't expecting to act either the decision scraped through by a vote of five to four.

This is all quite exciting enough for anyone invested in Japan. But what was really clever about the BoJ's move is that on the same day the Japanese government pension fund announced some big shifts in its asset allocation.

It's going to be investing a lot more money in stocks. To be precise, the percentage of its money held in JGBs will fall from 60% to 35%. Its target for money held in Japanese stocks goes up from 12% to 25%, while it has raised its ideal holdings of overseas stocks by a similar amount.

As Gavyn Davies puts it in his FT blog: "This change will increase the purchase of Japanese equities by a further $90bn, and the purchase of non-Japanese equities by $110bn, all effectively financed by $240bn of bonds to the BoJ, and therefore ultimately financed by central bank creation of reserves." Put simply, the BoJ is effectively printing money to buy stocks, rather than bonds. "The combined effect is to introduce a new type of QE on an enormous scale."

On the fringes, it's also good news that the BoJ's focus is falling on companies in the JPX-Nikkei 400 which is essentially an index of Japanese companies with more shareholder-friendly policies, such as being willing to pay a half-decent dividend.

If Japan's companies are encouraged to treat shareholders better, then Japanese investors might be more keen to invest in their own companies using their new tax-efficient individual savings accounts (Isas).

Do you feel lucky?

Why does this matter? A lot of myths surround Japan's economy, which isless unhealthy (from the perspective of its own citizens at least) than many people imagine, as we note below.

Slowly but surely, if Abe's promised reforms and his efforts to improve the public finances somehow work out (which is by no means guaranteed), then Japan could once again look like a beacon of hope to the rest of the world too.

However, from a cynical investment point of view, the economy is not what matters right now. A lot of verbiage has been churned out in the papers this week, pondering what QE actually did for global markets. But one thing ispretty clear from where we're sitting if you print money, stockmarkets go up.

What Kuroda has made clear from his surprise attack on the markets is thathe really will do what it takes to get Japan to an inflation target of 2%, or perhaps beyond.

You just need to look at how he justified his actions. He cited falling oil prices which in fact are good news for Japan as a potential threat to his repeated promise to "drastically convert the deflationary mind-set" using "totally different" monetary policies from the past, and this action shows he's serious.

It's a little like the Dirty Harry' strategy that European Central Bank (ECB) boss Mario Draghi has used in Europe daring the market to bet against him except Kuroda is actually acting on his promises, whereas Draghi has so far just proved to be desperately good at bluffing.

So we have a determined central banker who it would be foolhardy to bet against. Against that, the fact that the economic outlook for Japan is pretty positive is just the icing on the cake. The falling oil price cuts the country's import bill sharply Japan spent around $160bn on importing petrol in the 12 months to August.

Meanwhile, wages are still rising. In September, basic pay (excluding bonuses and overtime) was up 0.5% on the year. That's the biggest rise in six years. Including bonuses and overtime, total cash payments were up for the seventh month in a row.

Pundits noted that, adjusted for inflation, real wages are continuing to fall. But with energy prices a very visible expense for most consumers set to fall, rising nominal wages should surely still be good for consumer morale.

Some analysts are fretting over the prospect of another consumption taxhike next October. But Kuroda's actions show that even if Abe decides to jack up Japan's equivalent of VAT again, the central bank will be there to step in and pick up the slack.

Meanwhile, the Japanese themselves are more upbeat one recent (and slightly odd) sentiment survey noted that the percentage of Japanese who would choose to be born in Japan (given the option of starting all over again) came in at 83%, up from 77% in 2009.

In short, stick with Japan. If you're not already invested, we suggest some of the best ways to buy in below.

Three myths exploded

1. Japanese women don't workJapan's government regularly talks about getting more women into work as being key to economic progress and a way to offset its demographic problems.

But when you compare Japan to other developed economies in terms of the proportion of women working, it's nowhere near as bad as the self-flagellation might have you believe 61% of women are in paid work, not much lower than the UK's level of 66% and better than the developed nation average of 57% (according to the OECD, a rich-country think tank).

Improving gender equality in the workplace may be a laudable aim in itself, but simply getting more women to work is no more of a game-changer than it would be in any other similar nation.

2. The misery of the lost decades'Japan is often seen as the ultimate economic cautionary tale and in investment terms, it's not been fun for anyone who might still be hanging on to Japanese assets they bought in the late 1980s.

But if you measure economic success by the standard of living of a nation's citizens (which strikes us as sensible), then there are worse fates than to end up like Japan.

As fund group M&G notes, if you look at GDP per head of working population (which helps to adjust for demographic differences), then Japan has enjoyed similar growth to Germany since 1991 hardly disastrous. It's also worth noting that GDP per head is higher than our own.

3. Everyone is old and about to retireJapan clearly has problems with an ageing population. However, as Singapore-based analyst Bernard Tan notes, at 1.4 babies per woman, the fertility rate is significantly above that of South Korea, Singapore, or Hong Kong.

Also, Japan has a relatively larger population of under-15s, which means that in the coming five to ten years more young people will enter the workforce than in any of its developed Asian rivals. "It is Japan that has the greatest headroom potential in developed Asia, demographically speaking."

The knock-on impact of QQE

The BoJ's actions have spurred a lot of talk of currency wars where countries compete to devalue their currencies being reignited. It's certainly true that the tumbling yen will cause concerns for countries that compete with Japan for export market share such as South Korea, for example.

However, the only foreign country that could really even begin to restrain the BoJ is America. And it's hard to imagine that the BoJ's actions don't have the tacit approval of the US, given its timing.

Firstly, for now a strengthening dollar isn't bad news for the US. America has a huge advantage in the form of its rampant domestic energy production, fuelled by the fracking revolution, which will mean it remains attractive as a production base for many companies, stronger dollar or not.

Meanwhile, with the economy strengthening, a stronger dollar will hold back inflation a little longer than would otherwise happen, making it easier for the Fed to justify holding interest rates at low levels.

Also, QQE has a lot of potential benefits for overseas markets as well as the FT's Gavyn Davies points out, the BoJ's actions mean that overall central banks will pump more money into the global economy next year than they did this year.

For all the talk of the end of QE, there's actually still plenty of global money printing going on. That represents a big safety net under the market, which we suspect the Fed will be grateful for.

So while there may be a yen/dollar exchange rate that makes the US start to object to Japan's actions, we're not there yet.

The BoJ's actions will also put a great deal of pressure on Europe. One of the biggest worries investors have at the moment is that Europe is going to turn into Japan that it will sink into a deflationary pit of economic despair and never return.

If Japan's solution of slightly unhinged monetary policy-making seems to be working, there will be more pressure than ever on Mario Draghi to do everything he can to push eurozone QE past German objections. And if it doesn't work, expect calls for Kuroda to get even more radical.

The investments to buy now

As regular MoneyWeek readers will know, we're big fansof investment trusts in general, they are an exception tothe rule that most active managers can't beat the market.

Two we regularly mention are the Baillie Gifford Shin Nippon (LSE: BGS) investment trust (Merryn is a non-executivedirector on this trust), which is up nearly 120% over five years according to Citywire, and Bailie Gifford Japan trust (LSE: BGFD), which is up around 106%. We don't like buying trusts when they trade above their net asset value (the value of the shares in their underlying portfolio).

But since Japan took off at the end of 2012, it's been hard to get either of these at a discount. BGS, which is at the small-cap end of the sector, currently trades on slightly lower premia than average for the past two years, so now might be a reasonable time to buy if you haven't already.

If you'd rather look for trusts with catch-up potential, others in the sector trade at more attractive levels. Aberdeen Japan (LSE: AJIT) is an excellent performer over ten years (up nearly 200%), and also over the past year (up 14.9%) and trades on a discount of around 6%.

On the small-cap side, Atlantis Japan Growth (LSE: AJG) is up around 70% over the past five years and trades on a discount of 5% or so, while Prospect Japan (LSE: PJF) a favourite of our regular contributor David C Stevenson is up by a similar amount and trades on a discount of 15%.

In both cases, these discounts are in line with each trust's average over the past two years, but if you expect interest in Japan to grow as it grabs more headlines, the discounts may well narrow.

If you want to bet on the yen falling as well as Japanese stocks rising, another option is the iShares MSCI Japan GBP Hedged (LSE: IJPH). This exchange-traded fund, which is hedged against the falling yen (in other words, exchange rate moves will have less of an impact on your overall returns), has done very well since late 2012, when the yen really started to slide.

There's every reason to expect that to continue. But be aware that by betting on the yen continuing to fall you're taking a more aggressive bet on Abenomics if it fails and Japanese stocks fall, the yen would most likely also rise against sterling. If you're hedged against currency moves, that will be no comfort.