Published: August 4, 2010

For Japan, the hits keep on coming. Just last week, China knocked the country off its perch as the world's second-largest economy, dealing a sharp blow to national pride. But this week's news is even more sobering. The Japanese Yen is surging to a 15-year high of around 85 yen to the U.S. Dollar. Why the sharp recent move? Because the U.S. Federal Reserve has recently hinted that it may start to resume "quantitative easing," whereby it prints money to inject funds into the financial system and spur banks to lend at greater volumes. As that move potentially pushes up inflationary pressures down the road, the dollar weakens.

For a country like Japan that perennially struggles to boost domestic consumption and instead relies on its major exporters, this could lead to real pain. First, its exports are quickly becoming less competitive. Second, any profits that are associated with exports will shrink at the rate that the currency is strengthening. This could not come at a worse time -- Japan is wrestling with a rapidly aging workforce and surging government debt (which is far higher than our debt levels, as a percent of GDP).

The demographic data are sobering. According to the U.N.'s Population Division, Japanese households are having an average of 1.4 children (well below the 2.1 replacement rate), and when coupled with restrictive immigration policies, it has led to a steadily rising average age. Roughly 20% of Japan's population is 65 or older. By 2050, that figure should rise to 37%, according to the U.N. The United States should see that figure rise from a current 12.3% to 21.0% over that time frame.

The Reserve Bank of Australia analyzed the impact of aging demographics on economies, and concluded that "as fertility continues to decline faster in the home economy, the home currency begins a sustained appreciation, first in nominal then with a lag in real terms. In the medium and long runs, the nominal and the real exchange value of the home currency settle at appreciated levels significantly higher relative to baseline." This means the yen could continue to hit new highs against the dollar for years to come.

As far as weakening the yen goes, Japan's options are few, which partially explains why new Prime Ministers have had increasingly short tenures in recent years.

What a strong yen means for Japanese ADRs
As a result, the risks to Japan-focused investments are rising (though the benefits to the U.S. are less clear cut). Take Honda Motor (NYSE: HMC) for example. Honda has done a great job of opening factories in many places outside of Japan, but the company still operates many factories at home. The rising yen means its labor costs are out of whack, right at a time when China is keeping a lid on its currency and countries like Vietnam, Thailand, Malaysia and the Philippines are gearing up to become export powerhouses. Shares of Honda have moved back up above $30 lately, but any sobering comments from management about the rising currency are likely to push shares back down.

Other vulnerable Japanese ADRs include Canon (NYSE: CAJ), Sony (NYSE: SNE), and Toyota Motor (NYSE: TM).

As its manufacturing competitiveness continues to weaken, Japan could look to emulate the Dutch or Swiss model, which focuses more on financial and trade services and ownership of foreign assets. But that may be hard to pull off as the company's finances weaken.

So what does this mean for the U.S. economy? As a clear negative, we should no longer count on Japan to be a steady buyer of our government debt. It may even look to shed some U.S. bond holdings, and that could push our interest rates up and/or further weaken the dollar.

But these changes could also serve to strengthen the competitive position of the U.S. worker. Relatively young demographics generally portend higher rates of consumer spending. And for goods and services that are best produced near the consumer, more jobs will be created. That means even more Toyota and Honda plants in the U.S., and fewer in Japan.

Action to Take --> There are few direct ways to go long on the strengthening yen. As some speculate that the yen is only going to get weaker if the U.S. Federal reserve follows through with plans to re-initiate a quantitative easing plan when it meets August 11th, investors might want to buy shares of the CurencyShares Japan Yen Trust (NYSE: FXJ) exchange-traded fund (ETF).

Investors can also seek out U.S. companies that have a strong retail presence in Japan and would repatriate more profits in terms of foreign exchange gains. Names like Coach (NYSE: COH), McDonalds (NYSE: MCD) and Tiffany (NYSE: TIF) come to mind, but it's unclear if the Japanese consumer will spend in such an increasingly dire environment.

Investors can play this news on the short side by seeking out funds that focus on Japan. For example, the iShares MSCI Japan Index (NYSE; EWJ) ETF would get hit if Japanese exporters take it on the chin. Or look to short shares of those large Japanese exporters noted above.

-- David Sterman
Staff Writer
StreetAuthority