The Big Turnaround

Quick now, what is the top-performing major stock market in the world this year, by a wide margin?

Would you believe Tokyo? As of the close of trading on April 24, the Nikkei 225 was showing an astonishing gain of 33.2 per cent so far in 2013. No one else even comes close.

What’s going on? Japanese stocks have been in the doldrums for a generation – literally. It was way back in 1989 that the Nikkei hit an all-time high of about 39,000. At that point, it appeared Japan was the world’s new economic superpower. American managers were flocking to the country to attempt to learn the secrets of the success behind Toyota, Mitsubishi, Honda, Sony, Canon, and other corporate giants. Best-selling books were written on Japanese managerial psychology and methodology. The upside seemed unlimited.

Everyone knows what happened next. Japan’s real estate bubble burst, the Nikkei plunged, and the country lapsed into a decades-long economic funk marked by stagnant growth and deflation.

Every once in a while the Nikkei would attempt to rally, only to see it dashed on the rocks of an aging population, inefficient governments, and a moribund economy. By the time the index touched its low in early 2009, it had fallen about 80 per cent from its peak of 20 years earlier.

Disenchanted investors abandoned Japan in favour of the hot new Asian story, China. Simultaneous with Japan’s decline, the Chinese leadership turned the country in a new economic direction, at first experimenting with a more open trading policy and then embracing it wholeheartedly.

Now we may be witnessing another seismic shift. China’s growth rate is still robust but slowing. Its stock markets are reflecting this: the domestic Shanghai Composite is off 2.2 per cent year-to-date while Hong Kong’s Hang Seng Index is down 2.1 per cent. The action has moved back to Japan, at least for now.

What has happened? It all started with the coming to power in December of a new Prime Minister, Shinzo Abe. His Liberal Democratic Party had campaigned hard on a platform of fundamental economic reform and Mr. Abe has shown that he means to keep those promises. In the process, he has intervened with the policy-making of the Bank of Japan to an extent that would be unthinkable here in Canada. He has pushed the conservative governors to double the Bank’s inflation target to 2 per cent (the same as the Bank of Canada’s) and to adopt an open-ended program of quantitative easing (QE) along the same lines as that used by the U.S. Federal Reserve Board. As well, he has encouraged the Bank to keep its key interest rate near zero for the foreseeable future.

The goal is ostensibly to stimulate the Japanese economy but one of the predictable effects of these moves has been to devalue the yen, thus making Japanese exports more competitive. Year-to-date, the yen is down about 13 per cent against the U.S. dollar and 12 per cent versus the euro.

The devaluation prompted howls of outrage from some countries who complained that Japan was deliberately debasing its currency to gain an export advantage. The issue was aired at the recent meeting of the G20 finance ministers in Washington where, to the dismay of some countries, the final communiqué absolved Japan of the accusations, stating that the country’s actions “are intended to stop deflation and support domestic demand”. The devaluation of the yen just happened to be a side-effect. Yeah, sure – there was a lot of wink-wink, nudge-nudge in that one. Nonetheless, the G20 has given Japan the green light to maintain its aggressive policies and the Nikkei responded accordingly, rising 12.2 per cent in April alone (to April 24).

The best way for investors to play the Japanese resurgence is through a mutual fund or ETF. Almost all the Japan-based mutual funds have posted gains of between 15 per cent and 25 per cent so far this year. One of the better long-term performers is the Mackenzie Focus Japan Class which shows above-average returns for all time periods from one month to 10 years. The latest one-year gain, to March 31, was 16 per cent. Year-to-date, the fund is up 22.4 percent (as of April 24). The MER is 2.65 per cent.

There is only one Canadian-based ETF that focuses on Japan: the iShares Japan Fundamental Index Fund (TSX: CJP). It is hedged back into Canadian dollars which means the returns are currency-neutral. It tracks the performance of the FTSE RAFI Japan Index, less expenses, and has an MER of 0.72 per cent. It is ahead 35.9% year-to-date but the Mackenzie fund has a superior three-year record.

In the U.S., iShares has three Japan ETFs available. The closest to CJP is the iShares MSCI Japan Index ETF (NYSE: EWJ) which invests in a blend of large- and mid-cap stocks. As of the end of March, it was up 11.5 per cent for the year in U.S. dollar terms.

There are also two ETFs that are more tightly focused. The iShares Japan Large Cap ETF (NYSE: ITF) tracks the S&P/Topix 150 Index which includes the country’s largest blue-chip companies. So far this year, it has lagged slightly behind EWJ with a first-quarter gain of 10.8 per cent.

More aggressive investors may be interested in the iShares MSCI Japan Small-Cap Index ETF (NYSE: SCJ) which tracks the index of the same name. It has outperformed its two stablemates by a wide margin this year, posting a first-quarter gain of 16.4%.

If you are considering investing, keep in mind that we have seen false starts before in Japan. The Nikkei has become notorious for building investors’ hopes and demolishing them. The same thing could happen again so don’t invest unless you’re willing to accept that risk.

This article originally appeared in the Internet Wealth Builder, a weekly e-mail newsletter that provides timely financial advice from some of Canada’s top money experts. For more information about becoming an Internet Wealth Builder member, go here.