Japan ETFs Try To Get It Together

The CurrencyShares Japanese Yen ETF FXY is up 12.7 percent year-to-date, a performance that easily makes it one of the best-performing exchange traded funds tracking a developed market currency. Predictably, this isn't good news for equity-based Japan ETFs.

To this point in the year, it's a matter of bad and worse for Japan ETFs. With the yen soaring thanks to robust safe-haven demand, currency hedged Japan ETFs are tumbling. For example, the iShares Currency Hedged MSCI Japan ETF HEWJ is down more than 15 percent while the unhedge iShares MSCI Japan ETF EWJ is down 4 percent.

The rising yen is damping inflation expectations in Japan, prompting some market observers to speculate that more deflation is in store for Asia's second-largest economy and that Bank of Japan stimulus efforts are falling short of the desired goals.

On the surface, many investors might criticize the lack of inflation, weak macro data and Japan’s corporate exposure to emerging markets as good reasons why Japan’s equity market should have played catch up.

“Deflationary pressures have weakened market confidence in the central bank, and hurt Japanese stocks. Japanese equities experienced record outflows in April, according to BlackRock research based on exchange traded fund (ETF) flows, and Japan is now among the worst-performing equity markets this year in local currency terms, with the TOPIX index down more than 13% year to date, according to Bloomberg data,” said BlackRock in a recent note.

BlackRock Inc. BLK is the parent company of iShares, the issuer of EWJ and HEWJ. Recently, the most voracious buyer of Japanese stocks and ETFs trading in Tokyo has been the Bank of Japan, indicating that local and global investors are losing enthusiasm for Japanese shares. That is a near-term headwind and one that says buyers need a reason or reasons to revisit Japanese stocks and the aforementioned ETFs.

Fortunately, the longer-term outlook is rosier.

“There are reasons to like Japan over the longer term, even as a strong yen contributes to Japanese corporate earnings downgrades. The “short Japan” trade looks increasingly crowded, Japanese stocks appear cheap (around 13x forward earnings) relative to their own history and to other markets, and Japanese corporate balance sheets in aggregate have low financing risk, BlackRock analysis suggests,” according to BlackRock.

EWJ allocates about 40 percent of its combined weight to consumer discretionary and industrial stock with financial services names garnering a weight of 17.5 percent.