Many observers have written off Japan as the basket case of the industrialised world, and the past...
Many observers have written off Japan as the basket case of the industrialised world, and the past year has certainly been very disappointing for investors in Japan.
Over calendar year 2000, the broad-based Topix Index fell by 25% Ã one of the worst performances of the post-war period. Today the market is no higher than 15 years ago, and sentiment is at rock bottom. Foreigners and private investors have retreated from the market, and many observers are writing off equity investment in Japan for another five to ten years.
What went wrong? Do today's depressed levels offer another opportunity to get into the market at attractive prices or are they simply a warning of what can happen when a bubble bursts?
Initially, nothing went wrong with Japan in 2000 Ã the economy and listed companies lived up to expectations. The problem for the market was the springtime sell-off in Nasdaq, and the consequent de-rating of technology, media and telecom stocks globally. In the final quarter of 1999 and opening weeks of 2000, Japan had experienced its own spectacular, if short-lived, internet bubble.
But all was not right with Japan and politics remained a particular problem. Another Prime Minister was lost, as Mori replaced Obuchi. Mori's political career had been based on the principles of silence and inaction and he did not fail to disappoint.
Anti-reform elements gained the upper hand in government Ã with the economy and the corporate sector doing well again, why not slow the pace of change? Banking reforms were deferred or cancelled, tax changes beneficial for the corporate sector were abandoned, and, perhaps most importantly to the stock market, the introduction of money purchase pension plans scheduled for October 2001 was postponed for at least six months.
In August 2000, the Bank of Japan ended its zero interest rate policy by pushing its overnight lending rate up to 25 basis points, a move it has since reversed.
The BoJ gave two explanations for its action. First, with the economy returning to a growth path, the danger of falling into a deflationary downward spiral had receded. Second, the banks' ability to lend money at virtually zero rates meant that many near-bankrupt companies were being kept on life support and slowing down economic reconstruction.
In the BoJ's opinion, if a company can't earn at least 25 basis points on its assets employed, it should be allowed to go bankrupt. Despite the protestations of US Treasury Secretary Summer that disaster now loomed for Japan, the market took the rate rise with equanimity.
The reporting season for interim profits in late October and November saw day after day of relentless good news about Japanese corporate profits being met day after day of selling, especially from American investors. With the global technology cycle in downswing and the US economy in danger of falling into recession, why hold Japanese shares, particularly as most gaijin portfolios remained stuffed with electronics companies?
The downturn in the market eventually undermined confidence in Japan. Both corporate capex and personal consumption Ã the two pillars of recovery Ã faltered in November and December, and deflation returned with a vengeance. Japanese companies began dumping stocks in front of the 31 March arrival of mark-to-market accounting, which will force companies to adjust their annual accounts for unrealised profits and losses on their share portfolios.
This has driven the Nikkei Dow Jones Index back to November 1985 levels. The sheer volume of continued selling from companies unwinding cross shareholdings will put a ceiling on the market for the next few weeks at least. Confidence has fallen to rock bottom levels, but can it sink still further?
Time to relax
Over the next few months, the Nasdaq will probably continue to set the tone, and it continues to be under pressure. The consensus of opinion is that after a slowdown in the first half of the year, the US will strengthen in the second half and the rest of the world's markets can relax.
But suppose the consensus is wrong; suppose the Fed's actions are insufficient to pull the American economy out of a tailspin. Alan Greenspan's reputation has been achieved in an environment of prices rising year after year and no Fed Governor has had to cope with deflation since the 1930s. So America may be due a slump. What happens to Japanese stock prices then? They go down in the short term, as will equity prices all over the world. But the next thing that happens is that capital will begin to move out of the States and into other countries Ã this is what happened when the bubble burst in Japan. For a year or so, equities fell in most major markets but then capital fled Japan and sought higher returns elsewhere. In some sense, the American bull was born from the Japanese bear.
As investors become disillusioned with the long-term outlook for the States, capital flows will push stock markets higher elsewhere. Japan will only benefit if it looks a favourable home for investment in its own right. If Japanese companies continue to seek ways to improve their returns on capital employed, then capital will find its way to Japan. Much of the world's mobile capital is Japanese, since after nearly twenty years of current account surpluses, Japan is the marginal supplier of capital for much of the world. If Japanese companies continue to do the right thing, money is coming home, and investors in Japan can forget about the ups and downs of Nasdaq.
Importantly for foreign investors, the Japanese corporate sector is in rude health Ã profits for listed companies are hitting new highs, and corporate free cash flow is at a record high of 6% of GDP. Improving returns on equity has become a standard target for most managements, who also realise that reducing capital employed or using existing capital more efficiently is at least as important as simply raising sales or improving margins on sales. Consequently, profits can even increase in a low-growth economy.
The Japanese consumer is in good shape, too. Although nominal incomes are showing very little increase, real spending power is growing steadily as prices fall, and this spending power is being augmented by the growing number entering the ranks of the employed. The level of personal savings are extraordinary, with personal sector bank deposits in excess of $100,000 per capita, much of it earning interest at less than 50 basis points. There is plenty of money in the hands of business and the consumer, and if they can be persuaded to spend and to invest, the economy will boom.
The public sector remains Japan's worry. Stimulus packages have brought gross debt to GDP levels up to 130% and rising. Japan's debt to GDP ratio is double the rate of the United States, although Japan currently funds its long-term borrowings at 1.5% and the US at 5.5%.
If all public sector debt were refinanced at current rates, then servicing the debt would be more than twice the burden as a proportion to GDP in the US as it is in Japan. With money so cheap and demand so low, the Japanese government should arguably be spending more, not less.
The news coming out of Japan over the next few months is bound to be discouraging. The economy will show further signs of slowing down, maybe even of falling back into recession. Analysts will begin revising down their corporate earnings forecasts and begin to worry that 2000 was the peak.
However, today's share prices already discounts these worries and Japan is already priced for disappointment. Today, the Japanese market trades on less than 30 times earnings, and nearly half of listed companies are on P/Es of less than 20 times fiscal 2000 earnings.
These are multiples similar to those prevailing in Western markets, but unlike Western economies, Japan is at the beginning of a prolonged upswing rather than at the tail end of a period of growth.
I believe the market is near bargain basement valuations and that good Japanese companies are doing the right things to prosper in the future.
But I do not see what particular factor today could push the market higher tomorrow. That is always the case at market bottoms. To anyone with an ounce of contrarian spirit, the fact that they are surrounded by bears is most encouraging.
Scott McGlashan is manager of the Close Finsbury Japanese Equity Fund
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