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The U.S. -- not Japan -- is the place to invest
For now, that is. Japan's stock market may be rebounding, but the nation has some huge financial and economic problems to sort out.
By Jim Jubak
So who's right? The U.S. investors and Wall Street advisers who are recommending Japan, or the Japanese institutional and individual investors who are buying U.S. stocks and bonds as fast as they can?
So far this year, U.S. and other overseas investors have put $75 billion into the stocks that make up the Nikkei 225 ($N225), Japan's version of the Dow Jones Industrial Average ($INDU). Wall Street investment houses have recently advised their customers to put more money to work in Japanese stocks, and a Merrill Lynch survey of managers of global mutual funds revealed Japan as their favorite market. As a group, they are overweight Japan and underweight U.S. financial markets.
At the same time, however, Japan's institutional investors have been dumping Japanese equities. In October, for example, the country's financial institutions sold $9.2 billion in Japanese stock. And in September 2005, according to the U.S. Treasury Department, foreign investors bought a record net $102 billion of U.S. stocks and bonds. (The data for October is due out on Dec. 15.)
A huge chunk of that overseas money is coming from Japanese investors who are on pace to easily surpass last year's net $174 billion purchase of U.S. stocks and bonds. Right now, it looks like Japanese investments in U.S. assets in 2005 will be at the highest level since 1989, when the U.S. government started keeping track.
That's what it looks like, and it all depends on what happens to the U.S. dollar and the Japanese yen in 2006.
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As long as the dollar stays strong against the yen -- or, even better, keeps climbing -- Japanese investors pumping money into U.S. financial assets will make out like bandits. But if the dollar starts to tank against the yen, those investors will lose their shirts. And U.S. investors who bought Japanese stocks will be swimming in profits.
Today, it looks like the best arguments favor a weaker yen and a stronger dollar into the middle of 2006.
Why they're coming to America
And it sure is easy to understand why Japanese investors have poured money into U.S. stocks and bonds.
- Who would buy 10-year Japanese notes? They yield 1.5%; the 10-year U.S. Treasury note yields 4.5%.
- Japan's investors, like investors all around the world, are more willing to take on risk when they feel better about the economy -- and the Japanese economy, projected to grow at 2.4% this year by the Organization for Economic Co-operation and Development, looks solid enough that investors are now willing to take money out of savings accounts and buy U.S. bonds and stocks.
- Sure, the Japanese economy is projected to grow by 2.4% this year, but the latest figures put third-quarter U.S. gross domestic product growth at 4.3%. Higher growth promises higher corporate profits and better returns for investors.
- Japanese investors, like U.S. investors after the stock market bubble burst in 2000, have a bad case of buyer's remorse. They got burned once -- for 20 years, no less -- by Japanese stocks and bonds. So this time, they'll start by putting their money elsewhere.
All this has produced an 18% appreciation of the U.S. dollar against the Japanese yen since Dec. 31, 2004, when the dollar sold for 102.68 yen. On Dec. 6, that same dollar bought 120.83 yen. Think of what the stronger dollar/weaker yen means to a Japanese investor. If a Japanese investor bought a U.S. dollar bond that paid $1,000 in interest in January 2005, that interest payment in U.S. dollars was worth 102,680 yen. That same $1,000 interest payment today is worth 120,830 yen.
And that kind of profit, of course, encourages more investors to bet on the dollar against the yen.
Dollar beats the yen
That's looking backward, of course. But I think these trends are likely to continue into 2006. Here's why:
- Japanese public debt is indeed unsustainable, and it will put tremendous pressure on the government of Junichiro Koizumi, which won the last election promising to reform the system, to do something. Just about everything that the government can do, however, will threaten to lower economic growth. That will make it extremely hard for the Bank of Japan to raise interest rates. If, as the bank fears, inflation accompanies the current economic revival, Japanese rates could go from very low, but still positive, to negative. And, of course, any Japanese interest-rate cut would widen the spread between Japanese and U.S. interest rates. That would pull even more money from Japan to the United States -- and further weaken the yen.
- The strength of the U.S. dollar isn't due just to money flows from Japan. Oil-producing countries, flush with U.S. dollars from big increases in oil prices, are keeping more of those dollars in dollar-denominated investments rather than taking a chance on the yen or euro. (So far this year, the dollar is up about 13% against the euro.) Those cash flows won't reverse overnight.
- In a world with so much cash seeking a profitable home, it's likely that so large a move as this one between the yen and dollar will end in speculative excess. For a while, at least, it will be profitable not just to go long the dollar -- in many cases right now, without the protection of any hedge to insure against a fall in the dollar -- but to actually short the yen in the belief that its fall isn't over.
The yen won't weaken against the dollar forever. I can think of scenarios that would put a pretty abrupt brake on the dollar's strength against the yen and other currencies.
- The U.S. bull market that began in October 2002 (the Dow industrials bottomed that month) is getting long in the tooth. A significant correction could convince investors that it's time to cut risk by adding non-U.S. financial assets.
- The Federal Reserve's interest-rate hikes could indeed overshoot their target and appreciably slow the economy. At the least, that would take a bite out of corporate profits. At the worst, the dip might be bad enough so that the Fed would have to cut interest rates. While that would trim the yield gap between the United States and the rest of the developed world, it would also weaken the U.S. dollar.
- The risks that lenders have taken in the latter stages of the boom in the housing market could lead to a spectacular train wreck or two in the financial sector. That might be enough to spook risk-averse investors out of the dollar and into other currencies.
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