The Japanese yen is falling against the U.S. dollar again… and that’s good news for investors in Japan’s stock market.
That’s because a weaker currency has historically resulted in positive returns in the Nikkei 225 Index – Japan’s main stock market index. Since 2009, the Nikkei 225 Index gained in each of the five years the yen fell against the U.S. dollar.
On average, Japanese stocks gained 24.8 percent during years when the yen fell against the U.S. dollar. In years when the yen gained, stocks fell an average of 0.3 percent.
There’s just one caveat – because these figures are in Japanese yen, they don’t take into account the potential loss investors face in U.S. dollar terms when the yen falls.
For example, an original US$10,000 investment in a yen-denominated stock will only be worth US$9,500 if the yen declines 5 percent against the U.S. dollar (assuming the stock doesn’t move).
But there’s a way to invest in Japanese stocks without having to worry about exchange rate fluctuations. More on that below.
So far this year, the Japanese yen has lost 1 percent against the U.S. dollar. The Japanese stock market, though, has gained 6 percent in yen terms.
Three situations when Japanese stocks do well as the yen falls
A falling currency is typically bad for business at home. It increases the cost of production by making imported inputs (i.e. raw materials) more expensive in local currency terms.
It also increases the financial burden on nations with significant external (foreign) debt. A weaker currency means more of a country’s local currency is required to service the same amount of interest on, say, its outstanding U.S. dollar debts.
A falling currency also weakens the purchasing power of consumers at home, as businesses increase the prices of goods sold domestically to account for higher raw material costs.
This all sounds like a poor environment for investors in the stock market.
But there are three key reasons why Japan’s stock market often rises when the yen drops.
First is Japan’s massive foreign investments. The Japanese are known to be among the world’s biggest investors internationally – from investments in new Toyota and Nissan automobile manufacturing plants in Europe to major infrastructure projects, such as high-speed railways in Asia.
As of the start of 2018, total outstanding Japanese overseas investment stood at US$1.54 trillion. That was almost double the amount at the end of 2012.
Since records began, Japan has made US$480 billion worth of accumulated direct investments in the U.S. alone as of 2018 – the third-largest next to the U.K. and Canada.
These investments overseas are reported back home in Japan in local currency terms, and they get an added boost when the yen falls – buoying corporate profits.
Second is Japan’s big export industry. It’s among the world’s leading suppliers of electronics, high-precision equipment, robots, automobiles and heavy equipment.
Japan is the second-largest exporter to the U.S. (It also runs a large trade surplus with the U.S., making it a potential target in U.S. President Donald Trump’s trade war.)
A weaker currency tends to help Japanese exports, because it makes Japanese products cheaper for other countries (like the U.S.) to buy.
For instance, Toyota Motors (Exchange: New York; ticker: TM), Japan’s largest car exporter and largest producer overseas, sees operating profits rise US$250 million for every one yen fall in the U.S. dollar’s value (i.e. from 110 yen to 111 yen per U.S. dollar).
Japan’s other big exporters like Sony, Fast Retailing, Toshiba and Mitsubishi also see profits rise as the yen falls.
This is why a weaker yen typically results in better Japanese stock market performance.
Lastly, tourism gets a big boost from a weaker currency.
Japan is expensive. Food, hotels and transportation cost a lot – particularly for tourists.
When the Japanese yen hit a 20-year high in late 2011, tourism revenue fell by 18 percent because (for visitors thinking in foreign currency) Japan was even more expensive than usual.
Since then, the yen has lost nearly 40 percent against the U.S. dollar. It’s fallen by an almost equal amount against the Chinese renminbi and the Singapore dollar.
As a result, tourism in Japan has boomed. From just 6.2 million tourists visiting Japan in 2011, the figure hit 31.1 million last year – a nearly fivefold increase.
Tourism revenues hit a record US$41.5 billion in 2018, which was a 232 percent increase over seven years.
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American Social Security is running on fumes.
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And one of them lets citizens of other countries collect income too.
Why the yen could keep falling
There are many reasons for the yen’s decline over the last seven years. One of the biggest is interest rates.
Since the Bank of Japan (BoJ) embarked on its quantitative easing (QE) programme in April 2013, interest rates have stayed flat for a long time. (QE is the process of a government buying its own debt to drive interest rates lower.)
As you can see in the chart above, the benchmark 10-Year Japanese government bond (JGB) is now yielding negative 0.086 percent.
That means an investor putting US$1 million into a 10-Year JGB will get only US$999,140 back after one year – that’s a guaranteed loss of US$860. So investors are looking elsewhere.
Putting the same US$1 million in a 10-Year U.S. Treasury (with today’s 2.45 percent yield) will return US$24,500 after a year (before taxes and inflation).
As long as interest rates are negative in Japan, we can expect the yen to continue its downward trend.
That means investors should start paying attention to Japanese stocks. But as I mentioned earlier, a falling Japanese currency could eat up gains for investors in Japanese stocks when converting to U.S. dollars (or any other currency that gains against the yen).
One way to go long Japanese equities without the risk of currency fluctuations is an exchange-traded fund called the MSCI Japan Hedged Equity ETF (Exchange: New York; ticker: DBJP).
The DBJP tracks the holdings of the MSCI Japan Index, but hedges out the currency exposure that would otherwise be inherent in investing in Japanese-listed stocks.
Editor, Stansberry Pacific Research