Long Japan, Short Emerging Markets

A long-term trade that looks particularly interesting to us is to buy Japan and short the Emerging Markets. But there is a twist... The suggestion here is to do a "dollarized" version of the trade, which is to say, go long the Yen and short a basket of Emerging Market currencies versus the U.S. Dollar. The easiest way to do this is to go long and short the exchange-traded funds EWJ and ADRE, respectively. The former gives one long exposure to the MSCI Japan Index, and the latter gives one short exposure to the Bank of New York Emerging Markets 50 Index. There are several reasons why this trade is appealing:

1) The ratio chart of EWJ:ADRE is carving out a bottom that is almost a decade-long in the making.

The chart above depicts one measure of the relative performance of EWJ versus ADRE. It has all of the characteristics of what some might call a "bearish to bullish reversal". What we see is a trade that was under pressure for several years that is now "coming to life". We have a "breakout" of sorts, and a "throwback" to a very long-term trendline. The expectation is that a new valuation zone is beginning to emerge, one that is above the tops of 2013 and 2014. Admittedly, the "reversal" was in its early stages in 2013, but if one were to "zoom out" on this chart (not shown), and go back to the early 1990's, one would see that, relative to this time period, the trade is still in its early stages.

Shown above is a ratio chart. The ratio chart is especially popular among market technicians and economists alike. Historically, it's been used by market participants to track the price of the S&P 500 in Gold, the price of Gold in Oil, or to track Gold in Euros or Yen. In fact, a graph of any currency pair is a ratio chart of the respective currencies, each in terms of another base currency. There are some subtleties that are beyond the scope of this post that make it, mathematically, not "perfectly the case". But keeping the bigger picture in mind, the ratio chart is a useful tool to track the relative prices of just about any pair of securities.

So a ratio of the price of EWJ:ADRE looks interesting. The next step is to make sure that the "parts that comprise the whole" also look interesting (or to at least, make sure they don't contradict the message of the ratio chart). To do that, we take a look at the component securities. What do the MSCI Japan Index and Emerging Markets ADR 50 Index look like on their own?

MSCI Japan Index

The chart above spans several decades and depicts a breakout of a large consolidation zone that began in the late 80's. 

The chart below spans several years, and is completely neutral, that is, without any particularly bullish or bearish interpretations. 

Bank of New York ADR 50 Index

By looking at the parts that comprise the "whole trade", long EWJ, short ADRE, we certainly don't see anything that would give pause by posing any sort of contradiction to the larger message.

2) We've been cautious on the U.S. Markets beginning in late April. See our earlier post here:Tread Lightly! By taking an equal dollar amount long EWJ, short ADRE, the trader is actually statistically short the S&P 500. This is because the beta of EWJ is about 0.75, and the beta of ADRE is about 1 versus the S&P 500. The net beta is about -0.25.

3) EWJ is implicitly long the Yen, and ADRE is implicitly long a basket of Emerging Market currencies. Thus, by pairing EWJ:ADRE, the trader is implicitly going long the Yen versus the abovementioned basket of currencies. The Yen tends to rise with market weakness, and Emerging Market currencies tend to fall with market weakness. Thus, this is also a defensive currency trade that is in-line with our cautious stance.

4) Should the broader commodities market resume its downward long-term trend, Emerging Markets should follow in-tandem.

5) Japan is at least 11 years ahead of the U.S. in its fight against powerful deflationary forces. They appear to be "all-in" from a fiscal and monetary standpoint, while the U.S. appears to be lacking any meaningful fiscal support. This is a sign that Japan has finally come around to garnering the "political will" to fight deflation, while the U.S. seems stuck in its own political "red tape". Our bout with deflation shares many similarities to Japan's, but time-wise, the U.S. is probably where Japan was in the early 2000's, politically speaking. Japanese equities did not perform particularly well in the 2000's.