Why Japanese Stocks Could Falter

So, while Japanese equities have done well lately, it’s important to remember that their performance has been driven by the results of Abenomics, namely quality earnings growth and shareholder-friendly policies, rather than just multiple expansion.

The Japanese market does face potential headwinds, including high public debt and an aging and shrinking population. In addition, there are a number of scenarios that could derail the rally in Japan, such as a significant global slowdown and inflation stemming from a declining yen. But these scenarios seem unlikely today. Given all this, Japan may remain a stock market worth considering.

Exchange traded funds (ETFs) such as the iShares MSCI Japan ETF (EWJ) or the iShares Currency Hedged MSCI Japan ETF (HEWJ) can provide access to the Japan market.

Why Japanese Stocks Could Falter

Market Realist – Japanese stocks could falter, as sovereign debt levels remain elevated.

Over the last few years, Japan’s government spending has soared. The aggressive fiscal stimulus, which is the second arrow of Abenomics, led to a debt level that is now more than two times that of Japan’s GDP (gross domestic product).

The graph above shows Japan’s total sovereign debt as a percentage of its GDP. It has increased from 175% in 2009 to its current level of 230%. This is the highest debt within the developed world (EFA) (VEA). Surprisingly, most emerging markets (EEM) have a better ratio than that of developed markets.

Interest rates need to stay low—and the economic recovery needs to continue—in order for Japan to service its debts. In a move to reduce the burden, Japan increased its consumption tax from 5% to 8% in April 2014. This has been a drag on the economy. In order to bring the debt levels down, economic growth would suffer.

However, catalysts listed in the previous parts should lead to decent stock returns (DXJ) for now. Investing in currency-hedged ETFs like HEDJ could help negate the effects of the depreciating yen.

Read Is It a Good Time to Invest in Japan? for more on whether investing in Japanese stocks make sense at the moment.