Japan: The great reflation play of 2013

The Dow Jones Industrial Average has jumped from one all-time record to another this year, and the index is up nearly 11% in 2013 as of March 14. But that’s nothing compared to Japan’s white hot Nikkei 225 Index, which is up nearly 20% to a four-year high. It’s the best-performing developed market in 2013.

^N225 Chart

^N225 data by YCharts

Investors are betting that Prime Minister Shinzo Abe’s nominee to run the Bank of Japan will open the monetary floodgates, buy government bonds and pursue a 2% inflation target to reflate the long-stagnant Japanese economy. The new leadership team at the BOJ, led by Haruhiko Kuroda, is awaiting approval from the Japanese Diet this week.

Viewing Japan as the mother of all reflation plays, foreign investors are pouring money into Japanese stocks at a frantic pace. Last week, overseas investors bought about $10.5 billion worth of Japanese equities. That matters since non-Japanese investors drive about 60% of the daily trading activity at the Tokyo Stock Exchange.

Abe is trying to simultaneously push the BOJ to weaken the yen to boost exports, and stoke domestic demand by creating inflationary expectations. Nomura estimates that Japan currently has about a $170 billion gap between current GDP and potential GDP. The yen has already weakened dramatically against the dollar. However, it’s uncertain whether the central bank can move Japan from its current deflation to moderate inflation. (For a useful guide to Abenomics, check out this recent post from Business Insider.)

US Dollar to Japanese Yen Exchange Rate Chart

US Dollar to Japanese Yen Exchange Rate data by YCharts

Princeton economist Paul Krugman thinks Japan’s unorthodox economic polices, while decades late, are the right prescription for what ails many rich-world economies since the 2008 financial crisis.  Abe is “pledging to end Japan’s long economic stagnation, and he has already taken steps orthodoxy says we mustn’t take,” Krugman noted recently. “And the early indications are that it’s going pretty well.”

Not surprisingly, Japan ETFs are raking in the cash this year. According to etftrends.com, iShares MSCI Japan (EWJ) has seen $1 billion in inflows this year. WisdomTree Japan Hedged Equity (DXJ) has attracted more than $3 billion so far this year.

DXJ Chart

DXJ data by YCharts

Photo: confidence

The investments discussed are held in client accounts as of February 28, 2013. These investments may or may not be currently held in client accounts. The reader should not assume that any investments identified were or will be profitable or that any investment recommendations or investment decisions we make in the future will be profitable.