The iShares MSCI Japan ETF (NYSEARCA:EWJ) is a value-weighted fund that provides exposure to the Japanese markets. On the ETF specifically, we prefer alternatives which achieve very similar objectives but with lower expense ratios. On the broader macroeconomic picture of Japan, we think that while an accommodative environment has served the market well, as well as the overall economy, it’s becoming a little more ambiguous as to whether the BoJ should keep rates low or not as it relates to the weakness of the Yen. On one hand, the desirable inflation dynamics are not materialising. On the other, the weak Yen is really hurting Japan’s corporate sector. A BoJ pivot would scare domestic markets and possibly cause some issues in broader credit markets. Care is required here.
The following are the top holdings.
The sector weightings are as follows:
Details to glean are that fixed capital intensive businesses are pretty dominant in Japan’s mix. Also, the top sectoral holdings of industrials and consumer discretionary are both very cyclical.
Another key data point on the ETF is the expense ratio at 0.5%. That’s quite high. The FLJP has a 0.09% expense ratio, obviously much lower. We don’t see a reason to not go with the FLJP instead since they have very similar exposures, weightings and both are passive ETFs. There isn’t some differentiator to consider around the fund managers.
While EWJ seems to get dominated by FLJP, a more efficient option, regardless of which you pick you have to have a view on the Japanese economy and markets. It really comes down to one thing. Can the Japanese achieve sustainable inflation, something it hasn’t had, still doesn’t have and actually wants in the current ultra-accommodative regime of monetary policy? Or will it have to pivot. If it pivots, it should be pretty bad for Japanese equities as the market is going to be more rational and sensitive to changes in cost of capital.
A pivot may also cause some issues in credit markets if it comes unexpectedly, as there is quite a lot of leverage in shorting Yen-denominated bonds and taking the proceeds to go long US Treasuries. A pivot would force these trades to unwind and could cause a lot of selling of Treasuries. Also, massive Japanese allocators will be able to revert to home bias, again causing a Treasury sell off. Anything that impacts US credit markets impacts the whole global market.
Whether or not the BoJ pivots depends on several factors. Firstly, it should be said that a reasonable consensus view is that they won’t pivot. The macroeconomic data from Japan signals economic weakness, driven by a non-reaction of consumer spending to wage increases, as well as a fall in corporate CAPEX and spending. Inflation isn’t very high stripping out supply side issues and Yen related issues, and even the headline figures aren’t that high. Japan wants inflation, so a pivot might be less likely on those grounds as tighter credit conditions may just prompt even less spending which would be counterproductive. Also, the BoJ commenting on speculation in property markets in Japan isn’t that good of a sign either as far as their general orientation looks. Governor Ueda is a known hawk.
However, it’s possible that the ultra-accommodative conditions are counterproductive themselves on the Japanese economic situation due to the effects it is having on the Yen. While Japan is a net exporter, and a weak Yen reduces imports and increases exports which should help GDP, the GDP contraction is being driven by weak CAPEX. Major companies like automotive and some machinery are benefiting from the weak Yen as they have large foreign revenues and quite large Yen denominated fixed cost bases, but these businesses are cyclical and are anyway worried about export markets. They aren’t increasing CAPEX especially willingly. Also, Japan is not a big adopter of EVs since they were early adopters of hybrid and have been satisfied by that in local markets at least – not too much secular CAPEX there yet. Meanwhile, companies with large domestic markets are really suffering on the weak Yen as terms of trade for oil are terrible, as well as for other imported parts and components. Their weak economics are causing slow CAPEX velocity. In other words, those who benefit from the weak Yen may not be increasing CAPEX (domestically at least) anyway. Expensive raw materials also impacts consumers. Many companies are trying to pass through costs, but consumers are cutting back and saving despite their paychecks having also seen a decent general rise this year. The inflation buck stops with corporates at the expense of their earnings rather than materialising in final products where inflation is measured since demand is softened domestically. A stronger Yen would be a major help for a lot of corporates.
Indeed, there is some initial speculation around a pivot. There is already talk about another major shunto in the coming year that will see wages rise again quite substantially. The BoJ will likely take this as a sign that the virtuous inflation cycle is beginning.
We think a pivot is more likely now than two months ago by quite a large margin. We’d be a bit careful with an EWJ bet on account of that.