2023-07-01 05:46:18 ET
Summary
- The Franklin FTSE Japan ETF (FLJP) is a low-cost fund that tracks the broad performance of the Japanese stock market, offering a significant expense ratio advantage compared to similar ETFs.
- FLJP has delivered strong returns of 13.8% this year, benefiting from the surge in the Japanese stock market, with the Nikkei 225 up approximately 29.5% year-to-date.
- The Bank of Japan's hesitancy to normalize its ultra-loose monetary policy, coupled with Japan's sustainable economic growth and robust consumer spending, are contributing factors that support FLJP's performance.
Fund Overview
The Franklin FTSE Japan ETF (FLJP) is a low cost fund that tracks the broad performance of the Japanese stock market. The ETF invests in mid- to large-sized companies which are listed on Japan's market, the largest in Asia. It has net assets of over $1.3 billion and is listed on the NYSE Arca exchange. The draw of this fund is its low expense ratio of 0.09% which is a significant improvement over the larger iShares MSCI Japan ETF (EWJ) which has an expense ratio of 0.50% and the cheaper JPMorgan BetaBuilders Japan ETF (BBJP). So far this year, FLJP has returned 13.8% as the Japanese stock market has been on a tear this year with the Nikkei 225 up about 29.5% YTD.
The fund has over 510 holdings spread across many industries. The industrials and consumer discretionary industries are the top holdings, accounting for over 40% of total holdings, 23.6% and 18.6% respectively. In terms of specific companies, the powerhouse consumer discretionary firms Toyota and Sony top the list of holdings, combining for a total of around 7.4%, while top tech and industrial companies fill out spots in the top 10. The broad scope of the portfolio gives us a general sense of the valuation of Japanese stocks. With a P/E ratio of 16.4x, it's currently cheaper than the S&P 500 index which is at 25.4x and even lower than the MSCI World ETF (URTH) valuation at 18.3x.
Current Situation
As mentioned before, the Japanese stock market is on a tear so far this year. Over the last month alone, the Nikkei 225 index is up around 6.5% which has pushed the YTD performance to a robust 27.3% as of the end of June 2023. The strength of Japan's economy and corporate earnings have bolstered investor sentiment this year as the rest of the world has struggled as a result of surging interest rates in major developed markets. Most recently, Japan's GDP growth in Q1 2023 beat analyst expectations twice as the first estimate came in at 0.4% QoQ (0.1% forecasted) and the second estimate came in at 0.7% QoQ (0.5% forecasted). On an annual basis, GDP growth was 1.3% YoY which tops its developed market peers in the euro area (1.0% YoY) and the UK (0.2% YoY).
Of course, it's important not to leave out that the GDP outperformance and the rising stock market have been supported by the Bank of Japan's ultra loose monetary policy that has been maintained since the Global Financial Crisis in 2008-2009. Indeed, the Bank of Japan still has its policy rate set at -0.1% and is still funding massive purchases of government bonds and other securities. It still does this despite the fact that its G7 peers have taken drastic steps to normalize monetary policy in the face of surging inflation across the globe. In the current cycle, the Federal Reserve has hiked rates 500 basis points, the Bank of England has hiked rates 500 basis points, the ECB has hiked rates 350 basis points (with more coming), and the Bank of Japan has not done anything. This is part of two reasons that FLJP can grind higher.
Hesitancy to Normalize Policy
The reason for Japan's ultra-loose policy was over a decade of anemic growth and unstable inflation during the 2010s which forced monetary officials to step in and support financial conditions which struggled in that period. This was the beginning of negative interest rate policy (NIRP) and the ballooning of the Bank of Japan's balance sheet as massive quantitative easing took place. Weak demand conditions manifested itself as deflation. Underlying inflation was rarely near the Bank of Japan's 2% target rate and has only recently recovered to those levels in the post-pandemic period. As of May, headline inflation is at 3.2% YoY, and core inflation (CPI less fresh food and energy) is at an even higher 4.3% YoY.
Based on current price data, it looks to be appropriate for the Bank of Japan to start to adjust monetary policy which, when it happens, will likely be a headwind for Japanese equities. As the chart above shows, the return of FLJP has been loosely linked with the annual increase in the Bank of Japan's holdings of government securities. The run good performance in 2023 has been timed with BOJ asset growth in 2022 and early 2023. If that were to be curtailed, FLJP returns would likely take a hit.
Recently, however, the new governor of the Bank of Japan made dovish comments at a central bank summit which suggests that monetary tightening is likely further out than the market expects. In his comments, Governor Ueda focused on inflation rates in 2024 hitting the BOJ's target while shrugging off the recent rise of inflation in 2023. In fact, he pointed out that he thinks that current "underlying inflation is still a bit lower than 2%" which is why the BOJ members agree on "keeping policy unchanged at the moment." This suggested to some economists that policy adjustment would be delayed beyond when they initially expected: "The likelihood of him having enough confidence [to tweak policy] by the July meeting is less than 50%" (Ueno, Mizuho Securities).
Economy Showing Sustainable Growth in 2023
As mentioned above, Japan's economy has been surprising to the upside recently, especially in its GDP reports, and the strength has also been borne out in other macro data. On the consumer side, spending has pointed to solid household financial positions. Retail sales were up 4.1% YoY in 2022, and to start the year, were up 6.4% YoY in Q1 2023 after a 2.4% quarterly increase. In April and May, retail sales were up over 5% YoY still, and in June, consumer confidence recorded a 17-month high which included consumers reporting solid income growth. That income growth comes on the back of an airtight labor market where the unemployment rate has been unchanged at 2.6% for over a year and the employment rate has returned to highs seen once in 2019 and, before that, not since the 1990s.
On the business side, data has been more murky but there are signs that an improvement in Q2 and beyond is in order. Private machinery orders ended 2022 roughly with a decline of -8.3% QoQ in the last quarter of the year as manufacturing firms struggled due to poor economic activity in China and the euro area. Data so far in 2023 has turned around with a 7.1% QoQ rebound in Q1 2023 and a further expansion in Q2 2023 expected at 2.8% QoQ. The services sector has been an important driver of growth here as it has offset the weaknesses of manufacturing, growing 3.2% QoQ in Q1 and 9.2% QoQ in Q2. Industrial production data is also a bit mixed but has some near-term upsides. Until recently, production growth has been slightly negative to start the year and has only recently rebounded into an expansion (4.7% YoY in May). The forecast for production in June foresees a 5.6% expansion in June.
Conclusion
FLJP 's upside comes from two broad macroeconomic factors. The first is the BOJ's reluctance to normalize policy. Loose monetary policy has been a major tailwind for Japanese equities, and if it is allowed to continue, can bolster performance in Q3 and Q4 of 2023. Based on Governor Ueda's recent comments, it looks like loose policy will not be adjusted this summer as he doesn't see recent inflation gains as sustained just yet. Even if policy adjustments come in Q4, they are likely to be slow and underwhelming compared to market expectations. The second factor is that Japan is experiencing a strong rebound in economic activity in 2023 that has so far bested expectations. Even more encouraging is the fact that the rebound has been supported by a strong consumer base that is fueling a resurgence in business activity through robust demand.
One Risk: Yen Weakness
There is one major risk to the above macro thesis and that comes from the possibility of further yen capitulation. Over the last five years, the ultra-loose monetary policy has kept Japan's currency weak against most other developed nation currencies with a focus on the USDJPY pair. As of the end of June, USDJPY has peaked above 144 again after reaching that point earlier in the year. Before this year, the pair hasn't reached this level since the currency crises in the 1990s. This trend could exacerbate worsening inflation, and the Bank of Japan knows this. Governor Ueda said that "We will monitor the situation very closely" which means that if yen weakness reaches unacceptable levels, the BOJ may be forced to adjust policy earlier.
For further details see:
FLJP: BOJ Delaying Tightening As Long As Possible