After three of the most difficult years in stock markets anyone in the investment community can re...
After three of the most difficult years in stock markets anyone in the investment community can remember, the mood has changed. The global equity market is up more than 24% since mid-March, with investors looking out for good news rather than waiting for the next disaster.
The Federal Reserve has clearly signalled it will act aggressively to promote growth. As Greenspan talks of building a firewall against deflation, investors believe we are moving into a new era of policymaking. Not only will interest rates remain low for some time, the Fed may also be giving consideration to unconventional policy, such as manipulating long-term interest rates by buying Treasury bonds.
The energy with which the Fed appears determined to fight deflation has been interpreted positively by bond and equity investors alike, and the inverse correlation between the two asset classes has been broken as government bond yields continue to fall alongside the rise in equities. At the moment, everyone's a winner. But if the Fed is successful in restoring global growth, as we believe it will be, equities should maintain their winning streak.
So where are the best equity opportunities? In our view, Japan currently offers the buying opportunity of a generation. The macroeconomic outlook remains dire but corporate dynamics, coupled with low valuations, are extremely compelling.
In a nutshell, the corporate sector is undergoing a three-year capacity and debt work-out. Once completed, financial flexibility will have been restored, allowing the sector to move back onto the front foot in terms of hiring and capital expenditure, leading to a balanced growth profile and an unwinding of the deflationary spiral that has paralysed the economy for so long.
This economy suffered a supply side shock in the early 1990s that resulted from the capital spending binge of the previous five years. Yet despite this, corporate cap-ex was maintained at levels that not only did not address the issue of excess capacity but actually exacerbated it. The Japanese corporate sector could justifiably be accused of being in denial.
But in the last year, Japanese companies have tightened their belts. Working capital has been reduced to 37-year lows and cap-ex cut below depreciation levels. This has led to a dramatic turnaround in the free cashflow profile of the corporate sector. Current levels of cash generation will be sufficient to pay down the excess debt accumulated in the bubble period during the coming three years.
With the corporate sector getting fit, Japan offers substantial upside in terms of profitability. Yet in valuation terms, the market is cheap compared to the rest of the world. It was largely unaffected by the US tech bubble and, in recent months, Japan's market leaders have come under technical selling pressures from pension fund selling ' daiko henjo ' and bank sales of cross shareholdings.
In the run up to fiscal year end, banks' and pension funds' selling has focused on the most liquid stocks ' in other words, the best quality companies in Japan.
Fed will ultimately engineer recovery.
Equities will benefit from low interest rates.
Japan offers a great opportunity.
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