The Yen has had a horrid year so far down about 14% year to date and down 10% in the past 6 months alone versus the U.S. dollar. "So what?" you may say. After all, your portfolio doesn't have much Yen exposure so you are not too worried. "Wrong answer", we say. There are several reasons why you shouldn't ignore this development. Here are some of them.
First a bit of background. It is not at all unusual for the Yen to experience large fluctuations in value. The value of the Yen dropped by 43% between 1995 and 1998, bounced back 21% from 1998 to 2000 only to drop 21% again between 2000 and 2002 (all against the U.S. dollar). Finally, during the period 2000-04, it regained 21% in value. In other words, this year's move is by no means extraordinary. On the contrary, past experience suggests that the Yen could fall further.
But why is the Yen falling? There is plenty of evidence that the Japanese economy is now on a relatively firm path to recovery. All other things being equal, shouldn't the Yen strengthen in value? In theory, yes, but all other things are clearly not equal. Something else must be astray.
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We have been through piles of research in recent weeks, looking for answers. Nobody has provided a better answer than GaveKal Research. It is really quite simple. As you can see below, Japan is by far the largest foreign holder of U.S. government bonds - almost $700 billion worth.
10 Largest Foreign Holders of U.S. Treasuries: (Billions of U.S. dollars)
Country Sep. 05 Jan. 05
Japan 687.3 679.3
China 252.2 223.5
UK 182.4 101.1
Caribbean 102.9 94.2
Taiwan 71.8 68.3
Germany 63.5 53.8
Korea 61.7 53.6
OPEC 54.6 67.0
Hong Kong 48.1 45.3
Canada 47.8 35.4
Source: The Federal Reserve
In recent years, the Japanese have hedged their currency risk, because it was cheap to do so (when then Fed Funds rate was 1% it would cost about 1% per annum). The Japanese were still left with a very attractive return when compared to Japanese government bonds. Now, with the cost of hedging much higher as a result of the Fed Funds rate having moved from 1% to 4% in just 18 months, the Japanese continue to be net buyers of U.S. government bonds as you can see from table 1, but they no longer hedge. The net result? Less support for the Yen, so it falls out of the bed.
From experience we also know that when the global economy begins to lose momentum, Japan's current account surplus shrinks and the Yen usually starts to decline in value. So perhaps the Yen is telling us that the global economy is weakening, even if the economic data is not yet confirming it.
There appears to be a strong link between the USD/JPY exchange rate and central bank reserves (a measure of global liquidity), although reserves lag the exchange rate by about 6 months on average.
In other words, the falling Yen could very well be telling us that global liquidity may deteriorate further before things start to improve again. And, as you may know from our previous letters, deteriorating global liquidity is a bad omen for global economic growth. Could it be that the sick Yen is a sign of slowing economic growth?
Secondly, if you invest in Asia, you are strongly advised to remind yourself what currencies can do to stock markets. If you remember 1997-98, you would probably agree that Asia is one of the most currency-sensitive regions in the world. Many Asian countries continue to link their currencies closely to the U.S. dollar. The reliance on exports for economic growth becomes a problem when the currency you are linked to appreciates in value as much as the U.S. dollar has against the Yen in recent months.
Thirdly, even if you don't own a single share in Asia, you still have reason to worry in particular if you own European equities. With the depreciating value of the Yen, Japanese exporters have received a massive competitive advantage over the past several months when compared to both European and U.S. competitors. This is probably less of an issue for the U.S. economy given the fact that the US consumer is still going strong. In Europe, however, export-led growth is absolutely critical.
For those European exporters that compete with the Japanese, this is not just a minor distraction. This is a massive blow to their competitive advantage. Corporate earnings amongst European exporters will face challenges next year as a result of the weakening Yen which we do not think markets have factored in at this point in time.
In fact, it is not just European stock markets which tend to weaken when the Yen falls in value. A falling Yen tends to drag down global stock markets as demonstrated in the link between the MSCI global equity index and the USD/JPY exchange rate.
The solution, one might suggest, may be to load up on Japanese equities instead. After all, if Japan is strengthening their competitive edge as a result of a lower exchange rate, why not buy Japanese equities?
Well, that is precisely what many investors have done and explains why the Nikkei index has doubled in value since its low point in April 2003. So you are not exactly early to the party, although there is probably a fair bit left in it. We do not proclaim to be experts on the Japanese equity market, but we hear that the bull run of the last couple of years has been driven largely by foreign investors with hedge funds playing a significant role. Japanese investors, on the other hand, have not been aggressive buyers of their own equity market.
Therein lies the opportunity, because it means that there is plenty of purchasing power left in the system, should the Japanese get a taste for their own market again. Partly for that reason, Japanese equities are probably one of the more attractive propositions available to global investors today.
At the same time that raises another risk factor which you can hardly afford to ignore. Since 1990, U.S. bond yields and Japanese stock prices have moved pretty much hand in hand (with a correlation of over 90%) suggesting that Japanese investors have played a significant part in driving down U.S. bond yields, as they gradually swapped out of poorly performing domestic equities into U.S. bonds.
If Japanese investors decide to come back to their own equity market, the obvious thing to do would be to sell their U.S. government bonds, in particular now where they are sitting on very handsome profits following the fall of the Yen. So a return of domestic money to the Japanese equity market could occur to the detriment of U.S. bond yields.
Bottom line, we think the risk/reward on Yen based assets is very attractive. Japanese equities should benefit from an improving local economy and stronger exports at the same time, although weaker prospects for global equity markets in general may reduce the upside potential somewhat.
Meanwhile, the Yen is starting to look desperately undervalued relative to both the euro and the U.S. dollar. So, although the Yen could fall another few per cent over the next several months (a possibility but not a certainty in our opinion), if you are prepared to look beyond the current bear market in Yen, there is probably 20-30% upside over the next 3-5 years.
By investing in Japanese equities you effectively bet on two horses for the price of one. We don't think it is very likely that you get both of them wrong as long as you remember not to hedge your Yen risk.
By Niels C. Jensen, chief executive partner at Absolute Return Partners LLP. To contact Niels, email: njensen@arpllp.com
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