The respected financial magazine Barron’s published an article this week titled “Invest in Japan”. Many feel that the increased spending needed to rebuild will actually provide a boost to their economy, which has suffered from slow economic growth and deflation for over 20 years. My thinking on the issue is a bit different.
Prior to the earthquake, we had little or no direct exposure in client accounts to Japanese stocks. We eliminated our largest holding, the iShares Japan Index ETF, back in 2009 for two reasons: concern about the level of Japanese government debt relative to the size of their economy and the aging of their population.
The ratio of Japanese government debt to Gross Domestic Product is over 200%, compared with about 70% for the United States. One reason that they have been able to operate with such a high debt level is the high savings rate of Japanese individuals. But with debt already at such a high level, the concern is that interest rates may rise significantly if new debt is needed to finance the reconstruction.
The issue with an aging population is relatively straightforward. As the population ages, there are fewer and fewer people entering the workforce to replace those who are retiring. This puts pressure on entitlements such as old age pensions and their national healthcare system. Without a pickup in economic growth, the only way to pay out the benefits that have been promised is issuing even more debt.
Why not buy stocks? On Monday, March 14, the Nikkei 225 index closed down 6.2%. As of yesterday, the Japanese market is down about 7.8% this year. Many investors look at dips such as this as buying opportunities. The kindest thing that you can say about a “buy-the-dips” strategy is that it works sometimes. The Nikkei 225 is currently down about 75% from its all time high in 1989. Even if you bought dips on the way down, you are going to be waiting a long, long time to make money.
While a price decline may be good reason to review a market, sector or individual company, it shouldn’t be the sole reason for making an investment. Instead, it should be a starting point for a more thorough review. In our view, the negatives in our original thesis have not changed. If anything, the current situation makes the Japanese market even less attractive than before the earthquake. Despite the currently attractive valuations of Japanese stocks, we believe the macro factors overhanging the economy are significant. Rather than viewing them as “cheap”, I would say they are “cheap for a reason.”
Why not buy Japanese Government Bonds (JGBs)? Because of the high domestic savings rate, interest rates in Japan are relatively low. The 10-year JGB currently yields about 1.23%, compared with 3.40% for a 10-year US Treasury Note. We do not find the current US Treasury yield to be attractive, so we are not particularly interested in an even lower yield overseas. An investor in JGBs is also taking on exchange rate risk if the Yen depreciates from its current level of about 80 Yen to the Dollar. JGBs will also be hurt if Japanese interest rates rise. There just doesn’t look to be much return relative to these risks.
This article has focused only on the investment implications of the recent disaster. Our hearts go out to the hundreds of thousands of people who are suffering from the earthquake, tsunami and reactor leaks. We encourage both our employees and clients to be charitable, and one organization among many that is trying to help is the American Red Cross. You can go to www.redcross.org and donate online, and direct your donation to earthquake relief if you choose.
Bill Hansen, CFA
March 25, 2011