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Tokyo stock exchange. Source: Dick Thomas Johnson under Creative Commons license

Last month, we examined three cogent reasons for investing in Japanese companies via the iShares MSCI Japan ETF (NYSEMKT:EWJ). Since our early December review, Prime Minister Shinzo Abe was able to maintain power in a snap election, and presumably has a clear path to continue his economic policies, popularly dubbed "Abenomics." 

As a refresher, Abenomics is comprised of three major initiatives, referred to as "arrows": quantitative easing by the Bank of Japan to weaken the yen and aid Japanese exporters, aggressive fiscal stimulus in the form of government spending to spur economic activity, and structural reforms to the Japanese economy designed to increase corporate competitiveness and address stagnant wage growth. 

Abenomics was launched after Abe began his second term as prime minister in December 2012. While the first two arrows of Abenomics provided a temporary boost to Japan's economy, the first significant implementation of the third arrow, a consumption tax increase from 5% to 8% in April 2014, caused the country to fall into a recession. As a result, GDP is projected to contract by 1.6% this year (Japan's fiscal year ends in March). The world's third largest economy certainly appears to be at a crossroads. As a result, the EWJ ETF may not have a clear path to appreciation in 2015; let's review three potential obstacles below.

Delayed GDP growth
Last year's consumption tax increase was initiated in part to deal with Japan's dramatic debt to GDP imbalance. According to Trading Economics, Japan's public debt is 227% of GDP -- the largest sovereign debt burden in the world. 

Raising the national sales tax to pay down at least some portion of these immense borrowings may be a necessary structural reform, but the move stunned the Japanese consumer, and plans to raise the sales tax further are on hold for the time being.

The sales tax increase proved a wall into which all momentum from previous reforms slammed headlong. The fiscal year will now finish in the red, and while the government projects 1.5% real growth in fiscal 2015, any sluggishness in this recovery may weigh on corporate earnings. The Japanese stock market has benefited tremendously to Abenomics to date: In the first two years of Abe's term, the Nikkei 225, the most prominent Japanese stock market index, has gained more than 65%. But with returns like these, it's not hard to imagine a scenario in which lower corporate profits cause investors to take profits in Japanese equities. 

Shorts and outflows

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Traders at Tokyo Stock Exchange. Source: Dick Thomas Johnson under Creative Commons license

Apparently, some traders aren't waiting around for such a possible outcome. According to Bloomberg News, short selling on the Tokyo Stock Exchange reached 37.8% of total trading value in early January 2015, the highest amount of short selling on record since the primary Japanese exchange started keeping daily records in 2008. The widespread shorting reflects skepticism that Abenomics, particularly the third arrow, will be enough to lift the Japanese economy out of its decades long, deflationary slump.

Similar pessimism has recently manifested itself in the EWJ. Data compiled by Bloomberg show that investors pulled $1.05 billion from the EWJ in the five weeks ending Jan. 5, 2015. This amount is equal to 7.2% of the fund's current $14.5 billion net asset value.

Of course, should the reforms of Abenomics finally coalesce in a tangible manner in 2015, shorts could run for cover, stimulating another surge in the broad-based Nikkei 225 index, as well as significant inflows into EWJ. In either case, expect volatility in both the Japanese stock market and EWJ this year.

Dollar on fire
Perhaps the strongest force that may cap U.S. investor's gains (or contribute to losses) in the EWJ, is the relationship of the U.S. dollar to the Japanese yen. Abenomics is in part predicated on a weaker yen to revive the fortunes of Japanese corporations, which are traditionally exporters of technology, computer equipment, electronics, and automobiles. 

Abe's hand-picked Bank of Japan governor, Haruhiko Kuroda, has certainly obliged the demand to undermine the formerly staunch yen, launching a quiver-full of monetary easing arrows, and weakening the yen considerably versus the U.S. dollar, the euro, and other major currencies.

Kuroda has had some help achieving his objectives from the renewal of the U.S. dollar. The dollar has rallied nearly 15% against a basket of world currencies during the last six months, as measured by the Amex "Dollar Index." This is due in no small part to the surprising strength of the U.S. economy in 2014.

Monetary easing combined with dollar vigor is a potent combination, as this comparison of the Dollar Index to the dollar/yen exchange rate shows. The dollar's surge against the yen is trumping performance against major currencies:

^DXY Chart

^DXY data by YCharts

While the yen's capitulation to U.S. currency boosts Japanese exporters, it's not such a great thing for EWJ investors, as the ETF is dollar-denominated. Those who are bullish on Japanese stocks but concerned about the mighty greenback may want to consider the currency hedged version of the EWJ: the iShares Currency Hedged MSCI Japan ETF

Course of action
As we concluded in December, the EWJ is at present an investment for those with patience and risk tolerance. Meaningful appreciation may be limited in 2015, as the two factors that would most lift this ETF, a resurgent Japanese economy, and some clawback of the yen's position relative to the dollar, may be a year or more away. For those who want to take part in a favorable outcome of Abenomics, there's little harm in waiting to commit funds until the success of Abe's policies is both imminent and unambiguous.

 

Asit Sharma has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.