The Bank of Japan Tankan supports a 2014 Japanese equity rally (Part 6 of 10)

Why there are great expectations for Japans corporate profits

Sentiment is very positive

The below graph reflects the strong recovery of corporate profits in Japan since the 2008 crisis (the red line on the left axis, in percent). With the yen weakening from 80 to 103 against the dollar since 2013, the corporate profitability diffusion index (the red line) has grown to over 40%. This means that the percent of survey respondents who consider the profitability outlook “favorable” minus those who consider it “unfavorable” is 40%. For example, if 60% of respondents noted “favorable” and 20% of respondents noted “unfavorable,” the diffusion index would provide a reading of 40%, as below. This index ignores the middle-of-the-road choice between “favorable” and “unfavorable”—“not so favorable.” Regardless, the below graph would suggest that Japanese corporates haven’t been so positive about the profit outlook for many years.

The yen must weaken to support the rally

The recovery in corporate profits is very much driven by Japan’s weakening yen, which has weakened nearly 30% since 2013. The black line in the above graph reflects the average exchange rate between the yen and U.S. dollar being used by large companies in Japan. This is most important for exporters in Japan, which have a large percentage of sales in the U.S. dollar. The weaker the yen, the greater their profits. As the above graph reflects, on average, Japanese corporates are considering their profitability on a dollar-yen exchange rate of approximately 100. The exchange rate is currently closer to 103, though if the yen should continue to weaken above the 100 level, Japanese corporates could book larger-than-expected profits.

The continued success of the Japanese recovery under Abenomics may require the Japanese yen to weaken further. Should the yen not weaken over the course of 2014, the equity market may also languish. Should this occur, Japan may consider additional forms of quantitative easing later in the year, though the Bank of Japan seems to be staying pat with its current plan to grow assets to 270 trillion yen by the end of 2014, as we noted in the last article in this series. Yet the Bank of Japan may jump in if the economy weakens, as the sales tax just jumped from 5% to 8% last week. The Bank of Japan is watching this very closely.

Abenomics: Trying to reinvigorate the Yen carry trade

Given the aggressive monetary and fiscal policy of Prime Minister Abe and the Bank of Japan, the yen has weakened dramatically. Plus, the rate and level of bond buying operations and monetization of the asset base in Japan is expected to go full-bore through 2014. These monetary policies continue to weaken the yen. As a result, many Japanese exporters may hedge less of their foreign exchange risk in the future and simply let some of it ride. The “yen carry trade” is when investors, like hedge funds, borrow money in yen to finance operations or trading in other currencies and repay the load at a later date, buying back their short yen currency position—after the yen has weakened. This is a simple case of sell high, buy low.

As the above graph suggests, exporters seem rather conservative with their expectation for the dollar-yen exchange rate, at 100, which is fairly conservative in relation to today’s current rate of 103. Should investors and speculators gain confidence in the central bank’s monetary policy initiatives, the yen can begin to soften over 2014 and perhaps weaken toward the 120 level. Should the yen languish at 100, investors may have to curb their enthusiasm.

To see how Asian markets have lagged the U.S. market since 2013, please see the next article in this series.

For an overview of the U.S. macroeconomic recovery that could support Japan’s export economy, please see 2014 US macro outlook: The crack in the debt ceiling .

Japan’s equity outlook

As 2014 progresses, investors could see a continued outperformance of the Wisdom Tree Japan Hedged (DXJ ) and the iShares MSCI Japan ETF (EWJ ) versus China’s iShares FTSE China 25 Index Fund (FXI ) and Korea’s iShares MSCI South Korea Capped Index Fund (EWY ). For further clarification as to why DXJ could outperform both EWJ and other Asian equity indices, please see  Why Japanese ETFs outperform Chinese and Korean ETFs on “Abenomics .”  Plus, as Japan pursues unprecedented monetary expansion and the U.S. Fed tapers its bond purchases, Japanese equities could also outperform broad U.S. equity indices, as reflected in the State Street Global Advisors S&P 500 SPDR (SPY ), State Street Global Advisors Dow Jones Index SPDR (DIA ), and Blackrock iShares S&P 500 Index (IVV ). For more on how the U.S. Fed’s recent announcements could impact global equities, please see Will the Fed take a bite out of Apple ?