With stronger industrial production and export growth, and surging liquidity, the Japanese market has produced strong returns relative to other major markets in recent months
The last thirteen years have been unlucky ones for UK investors with exposure to the Japanese markets, with poor returns in absolute and relative terms. Recently however, the Japanese market has provided investors with better returns relative to all other major markets.
The purpose of this article is to consider whether exposure to Japan going forward will be positive in relative and absolute terms.
While the US equity market fell sharply amid growing concerns about future economic growth and equity valuation levels in the US, the Japanese equity market and economy has started to show signs of improvement in a difficult world environment. We have witnessed stronger lead indicators that have historically correlated well with positive equity market performance ' including stronger industrial production and export growth and surging liquidity and money supply indicators.
Year-to-date, in sterling terms, Japan has only lost 1% compared to US losses of 23% and 17% for the UK market. The Nikkei had hit distressed lows and foreigners were underweight. But then foreign fund flows started to shift away from the US into Japan. The yen also started to strengthen, reflecting the improving outlook for Japan and worsening US prospects.
We feel there are many similarities between the Japanese economic and equity bubble of the late 1980s and the US bubble a decade later but there are also many differences. The US's problems are not as extreme as Japan's and the US economy will respond more quickly to monetary policy.
However, other US excesses, discussed below, could still be a constraint on world growth going forward. The Japanese bubble was significantly larger and focused on equities and real estate, with heavy exposure to both from the banking system and corporate cross-shareholdings that made the overall economy vulnerable to falling asset prices. This meant a longer work out period for Japan.
This was met by a late monetary policy response from the Bank of Japan, which was still worried about inflation rather than focusing on the deflation that then hit Japan. This mistake should not be repeated in the US where rates have been cut aggressively and scope for fiscal expansion exists should it be needed. The US real estate market has not experienced the extremes seen in Japan and most of the US equity bubble was concentrated in internet and telecom sectors. While US corporate leverage is at record highs of 95% of GDP it is not as high as Japan's 220% seen in 1990. The US banking system is healthy with low exposure to telecom debts and healthy loan loss reserves. Labour productivity and Return on Assets Employed in the US still far exceed Japan's.
However, the US has significant problems that Japan has not experienced and hence our concerns about the future prospects for US growth. Examples of these worries include:
• A lack of US savings and high consumer debts and exposure to a sinking equity market (Japan's saving's ratio is 14% versus a low 4% in the US and Japan's consumers have only 7% of wealth in equities versus US's high 40% exposure).
• Second, the US has a massive current account deficit of -5% of GDP versus Japan's surplus of 2% putting downward pressure on the US$ for several years as dollars flow out of the country buying cheap imports. Inflow of dollars into US assets has stopped due to equity valuation and economic growth concerns. As US savings rise, this will lower consumption spending and GDP growth. Longer term, the weaker US$ will help the American economy as the current account deficit will fall and exports from the manufacturing sector recover.
• Third, while on the surface the US banking system looks sound with low exposure to telecoms and real estate, it has been guilty of massive exposure to derivatives and securitisation products estimated at $111 trillion world-wide, of which US banks hold 85%.
The total fall in US equities has so far wiped out $6 trillion of wealth and after the US accounting scandals investors fear that US banks will incur some losses on their derivatives exposure that has not yet been fully disclosed to the markets.
On the positive side for the US, the Government debt to GDP is low at 60% of GDP versus Japan's high debts of 160%, which means the US still has plenty of room for fiscal stimulus if their economy deteriorates. The US has learnt from the mistakes of the Japanese during its economic crisis and will lower interest rates further to restore growth.
The US has a banking system and corporates and consumers that respond more positively and more quickly to monetary policy measures than in Japan and the US government will take swift action to support financial markets and correct financial accounting irregularities. In terms of population dynamics, growth in the number of young people is notably higher in the US than Japan where the population had declined and where society is ageing at an accelerating pace.
Having said that the US will cope better with its problems, I would like to consider the likely drivers of the Japanese market.
Fund flow reflecting market capitalisation weightings in the MSCI World index had reached extremes over the last seven years. These reflected the fact that US weightings in the index had grown to 58% of MSCI benchmark weighting, due to equity gains and a strong US$.
MSCI weights for the UK at only 10%, Japan 9% and Asia including China at only 3% were clearly out of line with the world GDP contributions of these economies.
An adjustment phase has been required, and in light of the bad news on US equities, its economy and US corporate accounting scandals, this has been via a fall in the US stock market. US overvaluation worries have caused a rethink on high US weightings within global portfolios.
We foresee low economic growth worldwide as well as in Japan, with pressure on the US dollar and world bonds to remain strong. In the short term however, all stock markets are looking technically oversold, with better valuation and dividend yield support, and we feel a healthy rally is likely.
Investors may worry that these equity gains will not be sustained and we are also prepared to move to a more defensive and domestic Japan based, restructuring driven portfolio if world conditions deteriorate.
We remain positive in our outlook for the economy but accept that the bulk of the improvement has been export led and technology driven. The domestic economy and consumption spending will remain weak with no end yet to deflationary pressures.
Falling global stock markets and the fears of a weaker US recovery raise concerns about the sustainability of Japan's export led recovery, especially if the yen remains too strong, and erodes exporter profits. Japanese technology, autos and global cyclical stocks that benefit from a strong US economy and a weaker yen represent 40% of the Nikkei index and are vulnerable to these concerns. These sectors' weights therefore remain a key performance decision for any Japanese fund manager.
The US dollar had been strong for many years as US assets have been favoured but now this trend is reversing and this could be negative for the Japanese economy and exporter profits. The American consumer has pushed the US current account deficit to dangerously high levels at -5% of GDP and America now has to absorb 75% of all the world savings to fund this current account deficit which will be difficult to sustain.
Compared to its own history Japan is on cheap, record-low valuations with a PER (price earnings ratio) of 24 and falling to 20 next year after an expected earnings rebound of +45%. Japan's PBR (price to book ratio) of 1.5 is near 20 year lows with US PBR still at 2.6X and Europe 1.8X.
Japan's price to cashflow ratio of 7% is still cheap versus history and on a world basis. Japan's ROE is at 7% on an improving trend as corporate restructuring gathers pace, but still low versus America's 22%. A much overlooked factor has been the build up of Japanese savings, the collapse of US savings and ballooning US consumer and corporate debt levels.
The Japanese still save 14% of their earnings while the US had fallen to zero, but has now improved to 4%. As a percentage of American wealth, equities account for 40% compared with only 7% for Japan.
Most of Japanese wealth is safe in cash or deposits and while earning little interest, can act as a support to both confidence and consumption trends even in a low growth environment. The banking system is still weak but will work out its problems over a five-year period with minimum crisis for corporates and consumers.
Zero interest rates, plentiful savings and huge gains in bonds and term deposits have offset losses in equities and land and property. Longer term, as the world and Japan recover, the major bull point for equities will be the shift from deposits and bonds to equities to seek higher returns.
While we feel this is some way off, the equity market is at low levels, offering good value and plenty of opportunity.
Low interest rates, plentiful savings and still low unemployment has underpinned the Japanese economy. Corporate restructuring is proceeding slowly but surely, encouraged by the Government and increasing global competitive pressure from Asia and China. The stronger yen and deflationary trend in prices is keeping the pressure on management to keep restructuring.
We have seen increased mergers and acquisitions, labour shedding, early retirement, closure and sale of non-core assets, as well as withdrawal from unprofitable businesses. There is an increasing shift of production to Asia and China to lower costs and open up new markets.
We feel that while Japan moves slowly, it is moving in the right direction with positive daily announcements being seen. Some examples of positive restructuring changes from companies that both compete globally and dominate domestically include: Nissan, Honda, Ricoh, Canon, Kawasaki Steel, Rohm, Fujitsu, Shinetsu Chemical, Hoya, and Matsushita Electric Industrial.
It is our job as fund managers to highlight those companies embracing change and restructuring, and we feel we can continue to outperform our benchmark index, perhaps even sharply, over the coming years by this process.
We have shifted from a domestic, defensive, Japan-centric based portfolio that has served us well over the past quarter, to a more large-cap, blue chip index portfolio.
This has a higher beta and should perform well into any market rally over coming months.
We believe that this expected rally may ultimately run out of steam but we plan to participate fully. Once the rally has lost energy we will shift back to a more defensive and domestic Japan based portfolio.
This should insulate us from any fallout if the expected US recovery is anaemic or short-lived. We feel Japan will continue to outperform world markets and attract money flows from a rebalancing of MSCI assets away from overvalued and highly weighted US assets, to underowned and undervalued Japan.
While the US equity market fell sharply amid growing concerns about future economic growth, the Japanese equity market has shown signs of improvement.
Compared to its own history, Japan is on cheap, record-low valuations.
Zero interest rates, plentiful savings and low unemployment have all underpinned the Japanese economy.
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