Corporate restructuring, a more proactive monetary policy and attractive stock market valuations suggest that the most recent rally in Japan should lead to a more sustained recovery
After a long period of neglect, the Japanese stock market is once again on the radar screen of global investors. Merrill Lynch's July survey of fund managers' intentions shows Japanese equities have enjoyed a significant recent swing in their favour.
Most strategists have reversed their previous underweight recommendations and now advocate an in-line or overweight stance. Global fund managers, for whom an underweight position on Japan was an easy call, have moved to close their negative bets.
So, the stock market of the second largest economy in the world is back in vogue. But does this mark the end of a 13-year bear market and the start of a new uptrend or simply a phase of temporary relief?
On the face of it, even though things are moving in the right direction, there is little enough in the economic headlines to justify real excitement among equity investors. The economy expanded by 0.3% in the first quarter, driven primarily by continuing healthy exports, notably of capital equipment to China and of cars to North America.
However, improving data for the second quarter (+0.6% for GDP) suggests that Japan is returning to modest growth. Significantly, consumer spending increased by 0.3% in the second quarter, a welcome indication that the public is prepared to part with some of their abundant savings, despite continuing deflation. Even deflation has moderated from -3.5% to -2.1% since the first quarter.
All this suggests Japan is well placed to benefit from the apparent ability of the US consumer to carry on spending, despite high levels of debt, and from the phenomenal expansion of infrastructure and manufacturing in China.
The authorities can certainly take a good deal more of the credit for their management role than they are usually accorded. In contrast to the European Central Bank, the Bank of Japan (BoJ) has been intervening massively on foreign exchange markets to support the dollar and prevent the yen from appreciating and thereby undermining export prospects.
The impact of this is that Japanese companies have made significant gains in fast-growing Asian markets, especially at the expense of European countries, which have been disadvantaged by the stance of the ECB.
Moreover, according to some sources, the bank has been pursuing an expansionary monetary policy in not cancelling its dollar purchases by selling bonds to absorb an equivalent amount of liquidity. Unlike the US Federal Reserve, there is little transparency in the BoJ's policies.
However, its actions in dealing with bank bad debts, buying in bank equity holdings and in generally taking a growth-oriented stance suggest it is moving in the right direction. The appointment of a new governor, Mr Fakui, in March, seems to have made a difference.
The Koizumi government has been criticised for its lack of vigour in the pursuit of its restructuring programme, but this view gives too little credit for a number of worthwhile reforms, including measures to increase the use of temporary staff, changes in the bankruptcy law and a new law on corporate governance.
Much more needs to be done, especially to combat deflation and in reforming the tax system. The corporate sector has been more active in pursuing restructuring programmes, as the rise in unemployment will testify.
These have often involved overcoming deeply ingrained cultural habits and a general reluctance to embrace change. This process was initiated by multinational groups, especially those competing directly with US or European rivals in the global market place but has spread to smaller companies.
The benefits of restructuring are showing through in improvements in company profitability, which are being achieved, despite the lack of growth in the domestic economy. There is plenty of scope for further gains from these programmes.
Since hitting a 13-year low on 28 April 2003, the Topix Index has rallied by more than 25%. Cyclical and exporting sectors, notably iron and steel and machinery, have led the way, while more defensive areas, like food, oil & gas, pharmaceuticals and retail have languished. This closely follows the global pattern, which has seen investors taking profits on safe haven assets and rotating towards technology and other areas likely to benefit from global economic recovery.
The German and Japanese stock markets contain the highest weightings in cyclical sectors of any leading markets. So for optimists who expect a US-led global upswing to be sustained, Japanese equities, especially cyclicals, are probably a good bet.
The other significant internal market feature has been the strength of shares in smaller companies. The Topix Second Section Index has risen more than 30% so far this year, against 14% for the main index. Much of this outperformance reflects buying pressure in a relatively illiquid market.
However, as elsewhere in the world, shares in smaller companies tend to be more cheaply rated than their blue chip counterparts. Overseas buyers tend to go for well known, but more highly valued names. They should pay more attention to the potential which careful research may reveal lower down the size scale.
Three significant rallies occurred during the long bear market, in 1992-93, 1995-96 and 1999-2000. Each lasted for a year or so, with gains averaging around 50% subsequently being surrendered as the downward pressure on share prices resumed.
Official policy mistakes, like prematurely raising interest rates, played a major role in some of these reversals, although the most recent downward break, in 2000, was part of the global collapse in technology, media and telecoms sectors.
Given that there are so many structural issues overhanging the market, of which deflation and the weak banking structure are the most compelling, why should investors expect anything more than another bear market rally this time around?
We believe a combination of improving economic prospects, corporate restructuring, a more pro-active official stance and attractive stock market valuations should lead to further upside in share prices.
So far, Japanese institutional fund managers have remained generally sceptical of the rally, leaving overseas buyers and domestic private clients to make the running. This could change as improving circumstances become more apparent, especially if the lack of attraction in the main alternative asset, government bonds, is more generally accepted.
Japan is well placed to benefit from the apparent ability of the US consumer to carry on spending, despite high levels of debt, and from the phenomenal expansion of infrastructure and manufacturing in china.
Due to the continued strength of the yen, Japanese companies have made significant gains in fast-growing Asian markets, especially at the expense of European firms.
Like Germany, Japan has a high proportion of cyclical companies so is a good bet for investors who are optimistic about the global economy.
The Japanese government has introduced some positive policies including measures to increase the use of temporary staff, changes to bankruptcy law and a new law on corporate governance.
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