In last month's column, space did not allow me to explain why I had introduced Baillie Gifford Japan Trust (BGFD) into the Growth portfolio in December. Readers will know that both portfolios have tended to avoid Japan in the past, but the recent election of Shinzo Abe as Prime Minister could be a 'game-changer' - and not yet another false dawn.
False dawns
Japan's problems have been well known for years. The country is drowning in debt, and there are concerns as to its ability to pay the interest let alone the capital back. Around half of all government income is consumed by debt interest. A series of infrastructure initiatives over the years have failed to kick start the economy, and only added to the debt mountain.
And the debt keeps rising - government expenditure exceeds income. The deficit will be nearly 10 per cent of GDP this year. The situation has not been helped by a sluggish economy. A stubbornly high exchange rate has hindered exports with trade surpluses now turning into deficits. Connected to all this, the economy is struggling with deflation.
Governments have needed to raise income but found it difficult. One reason is that the population is declining and getting older, and this costs money. In the past, the government has been helped with its borrowing by its citizens' tendency to buy bonds. But bond yields and savings rates are now very low. This road is nearing its end.
It is therefore little surprise the stockmarket has drifted for years. There has been no shortage of false dawns - with 20-40 per cent rallies being relatively common. But they have all petered out because of economic reality. Many believe the catalyst needed to break this cycle of economic malaise is inflation. Previous governments have shunned the idea - enter Shinzo Abe.
The 'Abe Trade'
On 16 December, Japanese voters finally decided they had had enough of their deflationary predicament. The rapid deterioration in Japan's current account and its growing inability to finance her large budget deficits has this time forced political and policy change.
Shinzo Abe won a landslide election - a two-thirds majority - advocating an aggressive programme of fiscal stimulus, despite the size of the budget deficit, and almost unlimited monetary easing. Inflation is now the number one objective. He wants the Bank of Japan (BoJ) to instigate a 2 per cent inflation target, as compared to the present 1 per cent, and does not mind the extent of money printing it takes to get there. He has made it known that if the independent BoJ does not oblige, then he will rewrite the law so that he can fire the board.
An all-out attack on deflation is now being executed. Many have argued that the BoJ's deflation-fighting efforts in the past have been half-hearted. It has certainly lagged other central banks. Between mid-2008 and mid-2012 its balance sheet - reflecting assets bought with printed money - grew by only 7 per cent of GDP, compared to 14 per cent by the Bank of England and the ECB. There is scope for the BoJ to be more aggressive.
And the effect could be dramatic. Japan has been mired in deflation. Consumer prices are still at 1993 levels; this compares to a 60 per cent gain since then in the US. As a result, Japanese government bonds have been in a bull market for 20 years. Equities have disappointed. However, if rising inflation ends the bull market in bonds - and changes the mindset of the traditionally conservative Japanese investors - the money currently flowing into bonds will need a new home. Where else but equities? After all, after their bear phase, they now yield the same as US equities.
But rising inflation can take time to materialise. Shifting mindsets can take longer than envisaged to change. What may well be a sustainable fillip to the equity market in the shorter term is a weakening yen because of unlimited quantitative easing. A strong currency has hit exports over the years. And because the stockmarket is full of major exporters, equities are strongly influenced by fluctuations in the currency. A declining yen would be very bullish for equities. The yen-dollar rate hovered around 77 for most of 2012. Today it is 90.
And the equity market is cheap on any number of measures. Companies have grown their earnings by 50 per cent over the last 12 years and their return on equity, a key guide to profitability, has risen from 6 per cent to 10 per cent. A strong yen has encouraged cost-cutting and production being moved to lower cost countries in Asia. Many companies also trade at below book value - the 'break-up' worth of the company's assets. By comparison, the FTSE 100 sits at around one-and-a-half times book value. Furthermore, their restructuring has left balance sheets strong, whilst they spend more on R&D than any other developed economy.
In short, these companies are now lean and mean. But the stockmarket's spring coil has remained compressed for a long time because of deflation and a strong yen. Shinzo Abe's policies could well be the catalyst to change this. Investors should take note and profit from the 'Abe Trade'. Of course, this will not be a smooth road. The Japanese establishment is conservative by nature. The BoJ knows how to put up a fight. But a landslide victory and policy so far suggest this will not be yet another false dawn.
Portfolio changes
BGFD, introduced into the Growth portfolio in December, is run by the well-respected Sarah Whitley. The trust has a good track record and gearing of around 18 per cent which, when speaking with Sarah, confirmed their optimism for the market. It has done well in the short time it has been with us.
However, it tends not to hedge the currency. I have therefore increased the Growth portfolio's exposure to Japan by introducing an ETF which hedges the yen against the £ - namely the iShares MSCI Japan Monthly £ Hedged ETF (IJPH). This should mean UK investors will not have any equity market gains trimmed by the extent the yen weakens against the £. IJPH has exposure to the largest 300 companies which should also compensate for BGFD's modest bias towards the mid-caps.
I rarely use hedged investments, believing currencies are notoriously difficult to predict as politicians and central bankers often interfere. But it is warranted here given that a weakening currency is an important ingredient to the story. This purchase has been funded by top-slicing Temple Bar Trust (TMPL), whilst standing at a premium to NAV, and City Natural Resources Trust (CYN) – both having had good runs recently.
Otherwise, there were no changes to the Income portfolio.
