While troubles in the US such as accounting scandals and slowing GDP are taking their toll on the Japanese economy, there are still reasons to be positive about the country's future
Earlier this year, Japan's stock market was climbing, with investors optimistic about the recovery in the global economy. The OECD Leading Indicator had turned up and first quarter GDP data in the US ' the main driver of global growth ' was strong, with a year-on-year rise of 5.0%.
Because the fortunes of Japan's numerous exporters closely correlated with the OECD leading indicator, investors pushed Japanese shares higher. Between early February and late May, the Nikkei 225 index shot up by over 25%, outperforming most other markets, both developed and emerging.
In the last two months, however, things have changed. News about accounting irregularities at well known companies both in the US and Europe has dominated financial headlines and global stock markets have been dragged lower. While Japanese shares have not been affected to the same extent, they have not been left untouched.
More importantly for Japan, there has been a sharp slowdown in the rate of US economic growth. GDP for the second quarter grew at only 1.1% year-on-year, against consensus expectations of around 2.2%.
With Japan's domestic economy not yet strong enough to sustain a recovery on its own, there is still a degree of reliance on exports continuing to grow. The Nikkei 225 index has now all but lost the gains it made earlier in the year.
The key question for investors is whether this now changes the case for investing in Japan.
There is still optimism about corporate earnings and we have already seen encouraging numbers from some companies. The bulk of companies that reported results in May held few surprises, given already low expectations.
However, forward-looking statements have been fairly upbeat and generally well received. Furthermore, those companies that produce even more timely information through quarterly figures have also encouraged the market. Only a handful of Japanese companies currently report this frequently, but news from the likes of Honda and Sony has been good.
While weakening growth in the global economy does indeed impact Japan's exporters, we are not overly concerned by this as long as growth remains positive. Although a finely balanced equation, our forecasts suggest that nominal GDP growth in Japan will be slightly negative for this fiscal year, but move back into positive territory for 2003/4. These numbers assume that current levels of exports are merely sustained rather than continuing to grow.
However, the outlook starts to look very different if late this year and into next, we see a sharp fall in US consumer spending. Through lower exports, this would have a negative impact on manufacturing profits in Japan and therefore on the stock market. Such an occurrence is probably only an outside risk, but it is a possibility.
The impact on profits would likely be next year rather than this. Therefore it is not something that would have an immediate effect on earnings but it would certainly undermine sentiment.
Another concern among investors at the moment is the level of the yen. Although a strengthening yen enhances Japanese returns for foreign currency investors, it reduces the competitiveness of Japanese exports. Volatility in the US stock market and concerns over corporate earnings and accounting methods has led to US dollar weakness. The dollar/yen exchange rate has fallen to 120 from 135 earlier in the year. Again, current levels do not pose an immediate threat to our forecasts ' our profit predictions for companies like Honda, Sony and Toyota remain in place and we expect earnings growth form these and other leading exporters in the current year.
One product of the recent yen strength is renewed investor interest in Japan's domestic stocks. Given the ongoing problems in the domestic economy, these companies have often been ignored. However, there is now a strong and growing belief that Japanese companies are attractively valued relative to their peers in other world markets.
While not enough to offset the fundamental influences, foreign investors have been buyers of the market across a broad front in recent months. They have been encouraged by improving corporate news from many companies ' especially in the small and mid cap areas of the market.
Because small and mid-cap companies tend to be less dependant on exports than on the domestic economy, their progress is a good indicator of improving domestic demand.
Consumer confidence indicators have also improved over the last six months ' not significantly but enough to give cause for optimism. Although not yet at the upper end of their recent range, the trend is positive compared to that of twelve months ago. There have also been increases in housing and durable goods consumption.
If cyclical momentum in Japan's export-led recovery does wane, then the above is good news on the domestic front. Again however, our forecasts are not contingent on a consumer recovery in the Japanese economy ' the real key is restructuring.
While the government makes headlines for failing to tackle Japan's structural problems, there has been a strong undercurrent of improvement at an individual company level for some time. Many of Japan's more progressive companies are now completing three-year restructuring plans.
In the short term, this will generate a sharp rebound in reported earnings this year, as major restructuring costs fall out of the profit equation. For the longer term, rising returns on equity and leaner, more disciplined companies should enhance the stock market impact of even a very modest return to economic growth in Japan.
Evidence of this trend is provided by Japan's manufacturing capacity index. Capacity in Japan has been falling and is now back at levels last seen in the late 1980s. Over the last three or four years, this decline has accelerated.
Part of the restructuring theme has been a rise in Japanese merger and acquisition activity. Some deals have led to significant consolidation, in areas such as the paper industry for example. Just over 10 years ago, the top three participants held about 40% market share ' today this is nearer 60%. These developments are very important. Larger, more disciplined players are reducing costs, and making sustainable improvements in profitability.
To date however, all this activity has been agreed, and not hostile. The restructuring story will really begin to generate value when the more progressive companies that have already got their own businesses in order start to make hostile bids for their less efficient competitors.
Another positive change is the attitude of company directors to shareholder returns. The full-year results reporting season saw a very sharp rise in the number of companies announcing share buyback plans. While some of this may be motivated more by worries of takeover than by genuine concern for shareholder interests, this is no bad thing.
The fear of predatory shareholders might prompt more directors to tidy up their balance sheets. Given that the cash used to fund these deals is earning nothing on deposit, the potential for improvement in return on equity and earnings per share is very marked, offering the prospect of genuine absolute returns for shareholders.
Even based on conservative assumptions about the actual rate of execution, it is likely that over 1% of the total Japanese market's capitalisation will be bought back over the next twelve months. As cross shareholdings continue to unwind, this phenomenon will help take excess supply out of the market, restructure cash rich balance sheets and enhance shareholder value.
Another slowdown in US growth may hit Japanese exporters. However, with most commentators still predicting the US will avoid a double dip, the risks are limited. While the domestic economy remains something of a concern, there are several positive signs now emerging and any worries should be outweighed by the ongoing corporate restructuring and expected profits recovery.
With the scope for strong profits momentum over the next few years, and with valuations looking attractive compared to other major markets, there is room for optimism about Japanese equities.
With Japan's domestic economy not yet strong enough to sustain a recovery on its own, there is still a degree of reliance on exports continuing to grow.
Although a strengthening yen enhances Japanese returns for foreign currency investors, it reduces the competitiveness of Japanese exports.
Many of Japan's more progressive companies are now completing three-year restructuring plans.
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