In recent blog posts I’ve spent a significant amount of time thinking about and discussing the effect the recent selloff of emerging markets will have on the global economy. Continuing with this theme, today I want to take a closer look at the effect the selloff has had on Japan (WSJ article), the third largest world economy (here’s a full ranking for those who are interested).
As I explained toward the end of a previous post, investor doubt in emerging markets has sparked a huge capital flow into safe haven economies like the U.S. and Japan because they are traditionally considered a safe investment. At first glance, this seems like good news for the economies of the U.S. and Japan. A strong currency at home usually implies the economy is growing; consumers are optimistic and purchasing power abroad increases. Unfortunately, however, this view hasn’t been reflected in Japanese share prices. The 225-share Nikkei Stock Average is down 13% since the beginning of 2014, compared to only a 5.2% drop in the S&P 500.
A closer look at Japan will give us a good idea about why some investors are not confident about Japan’s future. As the article states:
“A year ago, optimism centered on the Bank of Japan‘s aggressive easing measures, which pushed down the yen’s value, which benefited large Japanese exporters by boosting the value of overseas earnings when converted into yen.”
It makes sense. Investors who had invested in Japanese companies previously were attracted to them because of the comparative advantage these companies had over companies located in countries with more valuable currencies. Now that this advantage is fading away, investors are worrying corporate profits will dwindle.
I would argue, however, that this view is a bit skewed. Although a strong yen hurts exports, Japan’s economy as a whole is showing signs of growth. These signs may even be strong enough for Japan to get out of its period of long-endured deflation:
- “Housing starts in 2013 rose to the highest level in five years”
- “Japanese industrial output was recently at its highest in more than a year”
- “The unemployment rate fell to a six-year low of 3.7%.”
Furthermore, as I’ve discussed before, I don’t think that the current capital inflow into Japan will last. After investors realize that their doubts in emerging markets were exaggerated by groupthink, capital will flow back out of Japan and Japanese exports will become more attractive once again.