2023-08-09 12:26:21 ET
Summary
- Japanese stocks have outperformed this year.
- The sustainability of this run will be tested, though, by the BoJ's move toward normalizing monetary policy.
- Having already re-rated, the HEWJ fund is at risk of a reset lower.
Japanese equities have been the surprise outperformer this year; while I had been cautious following the initial run through May, the momentum has only continued. With the benchmark Nikkei index now up to multi-decade highs, however, caution is warranted. Thus far, the weaker yen has been key to Japan's margin expansion, particularly for export-oriented sectors like tech and industrials, more than offsetting the (relative) underperformance of domestic sectors. In tandem, hedging out the yen downside risk (i.e., long Japanese stocks/short yen) has been a winning trade – the iShares Currency Hedged MSCI Japan ETF ( HEWJ ) has extended its outperformance over its iShares MSCI Japan ETF ( EWJ ) counterpart this year.
But the recent Bank of Japan ('BoJ' or the Japanese central bank) policy meeting indicates that a further normalization of Japanese monetary policy is on the horizon. In turn, Japan might finally be on the cusp of reversing the weak yen regime. Plus, investor positioning, exacerbated by an influx of foreign funds, has already driven equity valuations to multi-year highs, with the HEWJ portfolio now trading at ~15x P/E (vs. high-single-digit fwd earnings growth). With the dynamics that propelled HEWJ in recent years set to unwind from here, I don't see a compelling reason to own the fund.
Fund Overview – Invest in Japan Without the FX Downside
The US-listed iShares Currency Hedged MSCI Japan ETF, a vehicle to track large-cap Japanese equities without the currency risk, has seen its net asset base increase to ~$194m (up from ~$178m prior) following another quarter of outperformance for Japanese stocks. While the gross expense ratio screens richly at ~1%, BlackRock's fee waivers (in effect through 2025) mean the net expense ratio is closer to 0.5%.
The key underlying holding remains the EWJ fund, along with offsetting JPY/USD forwards. The aggregate underlying 237-stock portfolio remains skewed toward export-oriented sectors like Industrials (23.4%) and Information Technology (13.8%). Meanwhile, domestic-oriented sectors like Consumer Discretionary (18.7%) and Financials (11.7%) have lost ground over the last quarter. The defensiveness of the fund continues to shine through, with its equity beta vs. the S&P 500 ( SPY ) remaining relatively low at 0.5 despite the YTD gain.
Similarly, the HEWJ single-stock allocation is skewed toward exporters, with automotive leader Toyota Motor ( TM ) gaining share of the portfolio at 5.1%. Tech and media conglomerate Sony Group Corporation ( SONY ) remains the second-largest holding at 3.2%, while factory automation leader Keyence's ( OTCPK:KYCCF ) recent decline moves it below Mitsubishi UFJ ( MUFG ) in the top-five list. Electronics and semiconductor company Tokyo Electron ( OTCPK:TOELY ) is the other notable gainer. While still as well-diversified as ever, the fund's ~15x earnings and 1.4x book multiples mean HEWJ is now priced at an even wider premium to historical levels.
Fund Performance – Long Japan/Short JPY Continues to be a Winning Pair Trade
Following another strong quarter, HEWJ is now up +27.0% on a YTD basis (vs. +13.6% for the non-hedged EWJ) and has compounded at an impressive +10.0% pace in market price and NAV terms since its inception in 2014. The fund has notably outperformed across longer timelines as well, with the three- and five-year track records at +18.2% and +10.4%, respectively, far outpacing the EWJ's +5.6% and +2.9% returns over the same period.
While the long Japan/short JPY strategy has paid off well for HEWJ investors thus far, it's important to remember that this outperformance came during a period of extreme monetary easing in Japan. Hence, investors should be wary of underwriting more easing as Japan inevitably enters a new BoJ regime. In the meantime, the significant re-rating this year (without a corresponding growth in dividends) has led to HEWJ's yield declining to 0.9% on a trailing twelve-month basis.
Hitting the Reset Button with Yield Curve Adjustment
The abrupt tightening shift at the latest BoJ meeting took the markets by surprise, though it probably shouldn't have given core inflation pressures in recent months. To recap, the Japanese central bank will effectively raise the yield 'ceiling' for the 10-year Japanese Government bond (i.e., the 'JGB') to double the previous 50bps cap. While Governor Ueda did add a caveat at the post-meeting conference that the move was a precautionary one , the underlying message here is clear - the BoJ is finally on the path to policy normalization. Thus, its reaction function going forward will, to a greater extent, incorporate the path of global interest rates and FX trends. The knock-on effect of the JGB yielding 1% at the ten-year maturity shouldn't be underestimated, particularly for Japanese institutional investors, many of which have been forced into overseas bonds and riskier asset classes (e.g., equities) by the persistently negative domestic real rates.
Higher JGB yields, coming off an artificially depressed base, imply significant downside for equities. Some of the HEWJ's YTD rise will undoubtedly hold, helped by the recent inflation surge (now double the BoJ's 2% target), which has to some extent, come from the demand side. But given most of this year's rise has come out of the valuation side, helped by significant foreign inflows and multiple expansion (HEWJ now trades at a premium mid-teens P/E), the unwind could be just as spectacular. The earnings headwinds from a stronger yen shouldn't be underestimated either - HEWJ's export-oriented portfolio has benefited from the weaker yen and will, thus, suffer from an FX reversal. And in the meantime, emerging nominal wage growth ( expected to hit 2.5-3.0% YoY) points to more downward earnings revisions ahead.
Too Pricey with Japan Finally Set to Undergo Monetary Policy Normalization
While HEWJ has further outperformed in Q2 and early Q3, I think some caution is warranted at current levels. Yes, corporate Japan has experienced some earnings growth, but nowhere near enough to justify the ~27% YTD run. Instead, most of the outperformance has come from the valuation side, particularly from stocks in export-oriented sectors like tech and industrials that benefit from a weaker Yen. This leaves HEWJ vulnerable to an outsized de-rating as the BoJ unwinds its monetary easing and yen bonds regain some appeal. With the HEWJ portfolio also priced well above its underlying earnings growth potential at a mid-teens P/E multiple, I remain cautious.
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HEWJ: Too Pricey With Japan Finally Set To Undergo Monetary Policy Normalization