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A Yen for Yield

Most investors do not have sufficient exposure to equities outside the United States in their portfolios (a phenomenon known as home country bias), even though investing internationally is another way of introducing diversification in a portfolio. Investors interested in looking abroad may wish to look to the Far East – specifically, Japan.

Japan has been trading at a discount in recent years due to a number of economic challenges – as Russ Koesterich notes, it is the cheapest developed market right now. But a weak currency, while good for equities, may drive investors to consider hedging.

Attractive valuations

Japan remains reasonably priced in contrast to the U.S., just about every other developed market and even many of the emerging markets in Asia. Other markets, notably the United States, have seen prices driven primarily by multiple expansion, i.e. paying more for a dollar of earnings, while Japan has benefited from rising earnings.

A weaker yen

The Bank of Japan shifted its policy in late summer 2016 to buying government bonds, which started to weaken the yen. In addition, the difference between U.S. and Japanese interest rates has grown since the election, leading to further weakness against the dollar.

This dynamic creates a favorable environment for Japanese exporters – a crucial segment of the economy for the island nation. Secondly, it makes Japanese assets cheaper for foreign buyers, contributing to a positive outlook for Japanese equities overall.

japan chart

Source: Bloomberg, 1/10/17. Index returns are for illustrative purposes only.  Index performance returns do not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results.

Potential risks

The bullish sentiment is not without risks. Much of the optimism depends on continued yen weakness and central bank policy efficacy, which are not certain.

Still, Japanese earnings estimates are rising, and central bank equity purchases, rising corporate share buybacks and dividend payouts have been positive indicators for growth. Furthermore, investors can seek protection from yen weakness by considering products like the iShares Currency Hedged MSCI Japan ETF (HEWJ), which aims to mitigate the impact of currency fluctuations on returns.