The iShares ETF EWJ looks like a great short as it should be pulled down by the slowdown in BOJ asset purchases and falling earnings from its holdings due to the slowing economy and Coronavirus.

As the ECB looks to raise rates, the Yen will become the lowest-yielding currency which may force the BOJ to sell assets.

This comes as the BOJ slows its asset purchases and the government slightly raised its sales tax.

The Japanese economy fell at a staggering annualized pace of 6.3% in Q4 2019, nearly as bad as the U.S during the height of the recession.

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On Sunday, Japan announced that its economy shrunk at a staggering annualized pace of 6.3% of Q4 of 2019 (before the Coronavirus). To put that figure in perspective, the U.S economy shrank at an annualized pace of 7.3% during the worst quarter of the Great Recession. Economists blamed a recent sales tax hike and the impacts of poor weather. While these are certainly legitimate, economic data suggests that there may be a larger storm brewing in Japan, one that makes investments in the country like the iShares Japan ETF (EWJ) selling opportunities.

The Impact of Japan’s 2019 Tax Hike

The primary cause of the GDP crash was the 2019 sales tax hike that raised taxes from 8% to 10% on nearly all goods and services.

As you can see below, tax hikes like this have negative historical precedent on the country’s GDP:


The tax hike had a much larger impact than a comparable hike would in the U.S. Private consumption plunged 11% annualized and business investment 14%. Importantly, this hike was smaller than the previous 2014 tax hike though it had essentially equal economic impacts, signaling that the Japanese economy is not in a strong position.

The tax was made to fund the country’s increasingly insurmountable public debt load in an attempt to bring the budget deficit closer to even:

(Trading Economics)

Indeed, the areas of most U.S investors' complaints regarding the U.S monetary situation are worse in Japan. Debt-to-GDP is over twice as high and the government’s budget-deficit-to-GDP is as high (though historically higher). As you likely know, the Japanese economy and the Nikkei have been essentially stagnant for three decades despite extreme central bank intervention.

The Hidden Threat of Endless Quantitative Easing

The Bank of Japan is undoubtedly the master of quantitative easing. Since the recession, the country has printed around $450T Yen (about $4T USD) for asset purchases which are more than that of the U.S Federal Reserve. Remember, the Federal Reserve is backed by a $20T+ economy while Japan’s is around $5T, meaning central bank assets to GDP in Japan is more than five times higher than it is in the U.S.

As you can see below, the expansion of the BOJ’s balance sheet roughly correlates to the rise in the iShares Japan ETF (EWJ):

Data by YCharts

Of course, it should be noted that Japan owns around 75% of its entire ETF market with around a quarter-trillion in ETF equity holdings. Even more, with $475T Yen worth of government bonds on its balance sheet, the BoJ owns about half of all of its own outstanding debt.

This raises the question, why raise taxes at the expense of GDP when the government can effectively finance its own deficit?

The answer lies in the authority of the Japanese Yen. The Yen is viewed as an international safe-haven currency and that view has allowed it tremendous “seignorage” wherein the government effectively generates revenue by conjuring money. As long as the currency’s strength is unchallenged, the house of cards can continue to grow.

As you can see below, the Yen has been able to hold its weight against the U.S dollar and Euro over the past two decades with weakness going into the 2008 recession and temporal strength from 2009-2013:

Data by YCharts

The core determinant of exchange rates is the difference in interest rates. If one country pays a higher interest rate than another, money tends to flow into the high-interest rate country and boost its change rate. As you can see below, the directions in the value of the Yen roughly correlate to the interest rate differentials:

Data by YCharts

In the 2000s, when the Yen was in a steady bear market the Euro and U.S dollar paid interest rates about 4% higher. The gap subsequently rose to near zero in 2010 which fueled a bull market in the Yen.

This is seen better using real interest rates defined as one-month LIBOR minus core inflation. This is essentially how much one can expect their purchasing power to change given cash in a savings account. Investors want to use their cash today to increase purchasing power tomorrow.

As you can see below, all of the three major developed global economies have had interest rates with negative real returns over the past decade with the Euro being, by far, the worst:

Data by YCharts

The -2.1% figure in Europe means those who hold Euros in a cash-account can expect to lose slightly over 2% of their purchasing power a year, effectively a wealth tax.

The Japanese Yen is currently in between the U.S and the Euro. In Europe, leaders are beginning to realize that they have reached the limits of monetary intervention and have increasingly called for an increase in interest rates. While Europe has had the lowest real interest rate, its governments have also been able to generate surpluses and have drastically reduced government debt over the past few years while the U.S and Japan have been stuck in deficits.

After the latest GDP report, Japan also has by far the weakest economic growth rate of the three. This means that the BOJ will not be able to raise interest rates while the ECB can. Even more, the BOJ may need to cut rates in the face of rising supply-side inflation due to the supply-chain halt in China. As you can see below, Japan’s food-inflation has been on the rise despite a slowdown in Q4 consumer spending:

Japan Food Inflation

(Trading Economics)

This suggests that the Yen’s “real interest rate” is likely to soon crash which will most likely bring the Yen down along with it. The BOJ has already slowed QE - this will bring it to a stop and even potentially force the BOJ to sell assets. Since BOJ asset purchases have significantly propped up its equity market, this may mean EWJ and ETFs like it are headed for a crash.

Monetary Instabilty’s Effect on EWJ

The iShares ETF (EWJ) is the easiest way for U.S investors to gain exposure to Japan. The fund has been trading since the 90s and has $13B in AUM, making it among the largest ETFs. The fund holds the likes of Toyota (TM), Sony (SNE), and Softbank (OTCPK:SFTBY) and is highly correlated to the Nikkei 225.

As you can see below, the ETF recently made a “double top” that corresponded to its 2018 peak which is a technical signal that it’s headed lower. This is confirmed by its significant AUM outflows:

Data by YCharts

If U.S investors are selling the ETF (as seen in AUM) and it is still rising, it is a sign that Japanese investors (mainly the BOJ) are the ones buoying the market.

Of course, the ETF may seem cheap at first glance with a weighted average “P/E” ratio of 14X which is far better than that of the S&P 500 (24X+). However, we must remember that Japan’s economy has not grown in 20 years and has had zero net fixed-capital formation in 30 years. The country also has a staggering private-debt-to-GDP of 221% which puts its combined private and public debt at roughly 5X GDP (it’s around 3X in the U.S).

Japan’s economy is also heavily reliant on trade with China which will be suppressed this year due to the Coronavirus. Even more, after China and Singapore, Japan has the third-highest Coronavirus case-count with the same growth rate as China had early-on (30-40% per day).

Looking at the asset-sector breakdown of EWJ, we can see that it is highly exposed to the sectors that are likely to be hit the hardest from the virus:


Industrials and consumer discretionary companies are extremely supply-chain dependent due to base materials imports from China. They also need people to come to work and stores, two activities that have declined drastically in China which may similarly decline in Japan.

The Bottom Line

Overall, EWJ seems like a great short today, particularly if you’d like to maintain long exposure to the U.S. The ETF has been propped up by BOJ purchases which are likely to fall, has exposure to the Yen (its not currency-hedged like HEWJ) which is likely to fall, and has high exposure to COVID-sensitive industries.

The Japanese economy fell at an annualized pace of over 6% before the virus began, making it very likely that the virus pulls Japan into a recession in Q1 2020. Now that all the cards have been played, there is nothing the Japanese government can do to stop asset prices from dropping.

I would not be surprised if we see EWJ down 30-40% from its current level a year from today. In my opinion, the best way to make this trade is with a long U.S equity trade via (SPY). As you can see in the total return ratio below, this pairs trade has been a steady deliverer of alpha and is currently breaking out:

Data by YCharts

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.