But not only does a foreign investor in japanese stocks has to take into consideration the aforementioned cost and risk factors of the actual hedge, but also he has to form an opinion about the potential over- or undervaluation of the yen against its own currency. This can be a very tricky task as I regard currency valuation as one of the most challenging exercises.
The Yen: Some personal remarks
I have been investing in japanese equities for more than two years now and, as you might be able to imagine, have been through a few ups and downs already. As I am a european investor for me the EUR/JPY exchange rate is of main concern. Usually the yen appreciates against the Euro when the Nikkei goes down and depreciates when the Nikkei goes up.
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Especially in the circumstances of strongly trending markets (as it is the case at the moment) this correlation seems to be very robust. Although limiting my upward potential in Euro terms, I am very comfortable with this correlation, as it also has got a cushioning effect on my portfolio in draw- down phases. Hence, for the european investor the overall volatility of an unhedged japanese stock portfolio has been smaller than for a hedged one.
But be aware that correlations can and do break down from time to time!
The Yen: Undervalued, overvalued or fairly valued
In a fiat currency (e.g. a currency that is not directly backed by any tangible asset) the main determinant for the currency’s value is trust and faith in it by the public. The public here are economic actors who use the currency as a store of value, medium of exchange and unit of account. Trust and faith are qualitative metrics and hence very hard to evaluate.
Two charts illustrating what could destroy the trust and faith in the yen.
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But keep in mind! Those figures in the charts above are gross figures (ex- assets). Japan is one of the biggest creditor nations of the world. Japan's net government debt (Japan's assets included) is significantly lower.
Anyway, if Japan isn’t able to get its fiscal house in order and the fiscal situation is spiralling totally out of control, the public would loose trust and faith in the value of the yen. It would dumb the yen in anticipation of inflation pressure. The yen would depreciate, making imports into Japan more expensive. Interest rates would rise significantly as inflation finally materializes leading to further deterioation of confidence (The famous vicious circle).
If and when this will happen? Who knows!
Internal vs. external value of the japanese yen
The internal value of a currency is its purchasing power, e.g. the amount of goods and services one can purchase with one unit of local currency over time. As Japan has been in a (mildly) deflationary environment for quite some time now it is barely debatable that the internal value of the yen has risen.
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The following charts show the purchasing power of some major currencies over time.
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As you can see, only Japan and Switzerland were able to maintain a reasonable amount of purchasing power of its currencies over time
But as a foreign investor in japanese stocks we are less concerned about the internal value of the yen than with its external value, e.g. the exchange rate. There are economic theories, like the purchasing power parity theorem (PPP) and the law of one price, that deviate the external value (e.g. exchange rate) from its internal purchasing power. The most famous indicator based on a PPP analysis is the Big Mac Index, which trys to identify over-and undervaluation of a currency by comparing the Dollar Big Mac prices ( as of todays exchange rates) in various countries.
Although feed back loops between a currency’s purchasing power and its exchange rate definetly exist, there are a few economic metrics I regard as more relevant for influencing the exchange rate of a currency in the short and medium term.
A few of those will be discussed in the following paragraph
Current account
One of those metrics determining the yen's exchange rate is Japan's current account (= capital account + trade account). If a nation's current account is in surplus it usually is positive for its exchange rate as capital flows support the demand for the nation's currency, and vice a versa. Japan had been a surplus nation for decades. Unfortunately, at least for the trade component of the current account, this has changed lately .
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One of the main reasons Japan has locked in a trade deficit recently is to be found in the nuclear desaster of 3/11.. Having taken offline almost all its nuclear power plants, Japan is now more dependent than ever on gas and oil to satisfy its electricity demand. As Japan is a resource poor country those goods have to be imported and that puts enormous pressure on its trade account. On the other hand, giving that Japan has got such a huge pool of claims on foreign assets, I regard it as likely that its current account will get back into positive territory in the foreseeable future. The postive capital account will overcompensate the negative trade account.
Interest rate differentials
One of the most important metrics to determine the external value of the yen is its interest rate differential to other major currencies.
The idea behind this concept is that if Japan’s interest rates are significantly lower than the interest rates on other major currencies, one could borrow in yen at a favourable (low) interest rate and put the proceeds to work on higher yielding foreign assets (e.g. the famous carry trade). Money would flow out of the yen into other currencies and the yen would depreciate.
As we are living in a zero interest rate environment these days, nominal interest rate differentials are minimal or not existent on the major crosses and hence do influence the external value of the yen only marginally.
But what is about real interest rates (e.g. nominal interest rates – inflation rate)? Here the picture is rather favourable for the yen.
click chart to enlarge
click chart to enlarge
Japan has been the only major currency area (together with Switzerland) where real interest rates are in positive territory for quite some time now. In real terms German, US and British investors have been “loosing money” (e.g. purchasing power) on their local government bond portfolio and would have an incentive to invest in japanese government bonds (JGB). Demand for the yen rises and the yen appreciates.
In february 2012 the Bank of Japan (BOJ) changed its monetary policy stance and announced targeting (aiming for) an inflation rate of around 1%. So it is reasonable to assume that the favourable real interest rate environment is currently abating.
Central Bank's balance sheet
As policy rates of the major economies are already at or near zero, central bankers have embarked on so called "quantitative easing" (an euphemism for money printing) to stimulate its economies further.
click chart to enlarge
click chart to enlarge
Although Japan has been engaged in quantitative easing it has done so in a much lesser extent. Compared to the ECB, BOE and the FED Japan's central bank has expanded its balance sheet by only a fraction of the amount the other major central banks did. It's not new that the BOJ has been trying quantitive easing (with limited success). But it also has shown its willingness and ability to skim the excess liquidity (like it did in 2006 - 2007). Personally I am not too sure about the determination of the other major central banks regarding the willingness and/or ability to absorb the excess liquidity in the future.
Conclusion
Although the stable purchasing power over time is a net contributor to the yen's favourable exchange rate, I personally regard the real interest rate differentials and BOJ's limited balance sheet expansion (compared to the other major central banks) as the main driver for the yen's strength in the last years and in the coming future..
Japan's fiscal situation and the recent slump in its current account has to be viewed as a negative for the future evolution of the yen. Also the BOJ's change in its monetary policy stance (e.g. inflation targeting) might minimize the real interest rate differentials of the yen to other major currencies.
Given Bank of Japan’s track record in the past decades of keeping the yen’s internal and external value stable I am rather comfortable by holding the yen. I personally have more faith and trust in the Bank of Japan’s willingness and ability to guarentee internal and external price stability, than I have in my own central bank the ECB. And in the end faith and trust is the single most important criterion for the future value of a currency.
I would like to thank Scott Barber from Thomson Reuters Datastream and Mike Hewitt from dollardaze.org for the permission to publish there excellent charts on my blog.
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