With so much investor attention on the post-election “fiscal cliff,” the eurozone debt crisis and the once-in-a-decade change of leadership in China, investors may be overlooking some big developments in Japan, the world’s third-largest economy.
Since late September, the yen has weakened substantially due to increased speculation that the Bank of Japan (BoJ) will come under tremendous political pressure to embark on a massive quantitative easing program to weaken the yen and end deflation, which has plagued the country for two decades.
Exacerbating the yen’s fall during the past few days is Shinzo Abe calling on the BoJ to get aggressive on its current stimulus and begin an unlimited quantitative easing (QE) program to weaken the yen and reset its inflation target from the current 1 percent to 3 percent.
Abe is a former prime minister, the current leader of the Liberal Democratic Party (LDP) and, quite possibly, about to again become prime minister.
Indeed, Abe’s LDP is currently leading the polls for next month’s elections, and if it wins—and if Abe is serious about his intention to ramp up monetary easing—a new day may be about to dawn in Japan’s battle against deflation since its real estate and stock market unraveled more than 20 years ago.
This should be positive for Japanese equities, which have rallied strongly in the past few days, as the yen got punished.
That’s because a large component of Japan’s economy is export-driven, and there has been an inverse correlation between yen weakness and equity strength in recent years.
All this means that should Abe become prime minister and install an ultra-dovish governor at the helm of the BoJ who would zealously ramp up QE, investors should keep an eye on a number of ETFs.
I’ve long felt that with the yen sitting in the mid-to high-70 range, the way to play a rebound in Japan is through a currency-hedged product like the WisdomTree Japan Hedged Equity Fund (NYSEArca: DXJ) over a nonhedged product like the $4 billion iShares MSCI Japan Index Fund (NYSEArca: EWJ).
DXJ hedges its exposure to the yen by shorting yen futures and forward-contracts. It doesn’t necessarily carry a net short-yen exposure; rather, it neutralizes its yen exposure.
So, while DXJ’s short-yen exposure won’t directly juice the fund’s returns as the yen falls, investors in DXJ will get a purer equity exposure. That said, if the yen continues to weaken, Japanese equities should indirectly get a boost, which holders of DXJ will enjoy.
WisdomTree also recently announced a change in its index methodology for DXJ. Effective Nov. 30, 2012, DXJ will implement a filter in its methodology to place a heavier focus on multinational companies poised to benefit from a weaker yen.
Another currency-hedged product to keep an eye on is the db-X MSCI Japan Currency-Hedged Fund (NYSEArca: DBJP), which tracks the same MSCI index as EWJ, but with a currency-hedged feature.
In the meantime, investors with their Japan equity exposure parked in the popular EWJ are exposed to currency risk. That cuts both ways: They’re negatively affected by any losses in the yen, but of course benefit when the yen rises.
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