Japan's Currency Cushion

S&P believes recent Japanese equity performance highlights the importance of monitoring currency trends when evaluating international equity opportunities

The fundamental outlook for Japan may not be clear, but Standard & Poor’s has found that positive currency effects have helped equity performance. Despite significant local currency underperformance, the yen’s 6.2% rally vs. the greenback (through May 15) has Japanese stocks handily outperforming the S&P 500 year-to-date in U.S. dollars.

The reason why Japanese equity fundamentals are under pressure is because economic growth in the country continues to weaken. As a result, downward revisions to earnings have accelerated, S&P thinks.

Global Insight, an independent forecasting firm, expects 2008 Japanese real gross domestic product (GDP) growth of 1.5%, which compares with the 2007 reading of 2%. March exports rose only 2.3% from the year-ago period, the smallest gain in three years. We think that’s due to the negative effects of slowing U.S. growth and yen appreciation. In addition, growth in Japanese exports to China has slowed to a single-digit pace after seven years of double-digit increases.

On the domestic front, we think weak consumer spending leaves the Japanese economy more vulnerable to further slowing, if exports continue to weaken. Unemployment is only 3.8%, but our analysis indicates wage growth is soft. The March ratio of job offers to job seekers declined to 0.95, meaning that only 95 jobs were available per 100 applicants. This appears to have pressured household spending, which fell 1.6% in March.

Given the macroeconomic problems, the consensus expectation for 2008 Japanese corporate profit growth fell to 7.4% currently from 12% in December. While share prices declined, valuations have not. The S&P/Citigroup Japan index currently trades at 14.8 times estimated 2008 earnings, roughly in line with where it stood six months ago. Japan’s current 2008 estimated P/E-to-growth ratio of 2 is among the highest in the world.

On the currency front, year-to-date yen strength vs. the dollar has significantly boosted dollar-denominated Japanese equity returns. Hence, the outlook for the yen-to-U.S. dollar ratio is critical in evaluating the asset class’s prospects, S&P thinks.

S&P found that the yen tends to appreciate vs. the U.S. dollar when investors worldwide grow averse to risk. When the appetite for risk returns, the yen appears inclined to fall. Slowing global growth and credit market turmoil have favored the yen in 2008, as the unwinding of the carry trade boosted the currency vs. the dollar, S&P’s analysis shows. S&P also thinks the Federal Reserve’s aggressive interest-rate easing program and the steadiness of the rates in Japan pressured the yen-to-dollar ratio.

However, with the Fed unlikely to cut anymore anytime soon and with risk tolerance improving, the yen probably won’t continue appreciating at the frenzied pace seen in the first quarter. Furthermore, with rising inflation risks largely offset by slowing growth, we expect the Bank of Japan to remain on hold over the next few months. This is likely to inhibit yen-to-dollar appreciation. Japanese short-term interest rates remain a paltry 0.5%, 150 basis points lower than in the United States.

As a result of these factors, we believe the positive effects of currency translation are unlikely to remain the big driver of dollar-denominated, Japanese equity returns, leaving fundamentals to play a greater role.

With the fundamental outlook unclear, the positive catalysts necessary to boost outperformance aren’t likely to be found. But given the prolonged period of underperformance seen in Japanese stocks — which we think has discounted much of the bad news — we think Japanese equities are poised for more competitive returns.

Japan is the world’s second largest equity market and constitutes roughly 20% of non-U.S., developed, free-float, adjusted market capitalization. The S&P moderate global asset allocation currently dedicates a 12% total portfolio weighting to developed overseas equities, and Japan represents roughly 2.5% of this allocation. The developed international allocation in the conservative portfolio is 10% (2% to Japan), and is 19% (3.8% to Japan) in the aggressive portfolio. The S&P Topix 150 index exchange-traded fund (ITF) tracks Japanese equities.

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