Despite the need for structural reform in the country, rising saving levels, strong consumption and low inventories are indications that the market is finally beginning to improve for investors
Investors who have seen numerous short-lived rallies in the Japanese markets will be sceptical that the latest one can last.
The country's structural and political problems that caused 20 years of bear markets have certainly not disappeared but there are signs the market is now good value.
The latest rally has been relatively sustained ' the Nikkei 225 has appreciated by 6.3% from the end of April to the end of June and by around 1% since the beginning of the year. However, investors want to know if this is just the latest blip or the start of a more sustained bull market.
The rally in Japanese companies stems from rising optimism about world markets and recent positive data on Japan.
Ed Merner, president of the Atlantis Investment Research Corporation, says while the economy is still very depressed it is possible that Japan has experienced the worst .
Bob Burghart, analyst at ING Baring, cites the boost the market has received from encouraging economic figures such as low inventories, strong consumption and rising savings ratios. But he points out that savings ratios are high because wages are falling due to companies cutting costs and redundancies so people are drawing on savings to maintain their standard of living. This means that consumption has not necessarily increased overall.
The market rally was not the result of a better outlook for the Japanese economy but was rather caused by undervalued stocks, according to Merner. He says: 'There are still structural problems in the economy but the market has come down so far that there are a lot of companies with good valuations around. Multiples have come tumbling down and earnings are up significantly especially in the banking and financial sectors.'
One reason for the low valuations of Japanese stocks is the government policy of transferring all private pension funds to a state pension scheme, which took place at the beginning of this year. Burghart said: 'Pension funds were returning their funds to the government and they could not return stocks but had to return cash. So companies had to liquidate the funds and sell underlying stocks whether these were undervalued or not. Most big names got sold because pension funds tend to hold a lot of blue-chip stocks. This drove markets down.'
This contracting out of pension funds led to a lot of stocks that were favoured by internationally based fund managers and investors to be sold, according to Andrew Smithers, chairman of Smithers & Co. The underperformance of these stocks deterred foreign investors, who are key to stock market movements in Japan, to invest in the Japanese market. He says that foreigners sold ¥460bn worth of stocks in the three months to the end of April.
However at the end of the fiscal year, the pressure from pension fund selling ceased leading to more interest from foreign investors in the Japanese stock market. Merner adds that overseas investors have been selling overweight positions in bonds in the past few months in order to realign portfolios so as not to be underweight Japan.
Positive figures from the US economy helped to maintain the Japanese market rally, according to Burghart. He said the Japanese market fell in spring because of the pessimistic views on the US economy but now that the outlook for the US is more encouraging, the market has risen in anticipation of a rise in exports.
Smithers says the market fell at the beginning of the year because the Japanese financial services sector sold their equity holdings in order to restructure their businesses. Life insurance companies have been selling their shares because the industry is suffering from negative cashflow due to their mismatch in asset and liabilities. Japanese banks have been reducing their exposure to the market and the Bank of Japan has been helping them to do this by buying some of their holdings.
However, the central bank did not intend to hold on to the shares and sold some of them. Selling pressure has also come from non-financial companies, which have been selling their holdings because accounting rules in Japan are becoming more stringent and requiring losses to be recorded through the profit and loss account, says Smithers. This selling pressure eventually drove valuations so low that a buying interest was rekindled in the market. This suggests that the rally in the Japanese market is not sustainable because it was not driven by long-term changes.
Burghart says that although companies are restructuring in Japan, it is the structure of the economy that needs changing. The Japanese government has not managed to push through serious reforms. He says: 'Overall there needs to be economic reform and regulatory changes and this has not happened. The Japanese prime minister has a weaker role than a western democratic leader. The prime minister's power is weakened because of bureaucracy and vested interest with different industries. Unless there is co-operation with all parties, a policy does not go through.'
The government is not dealing with the fundamental problems of the economy, according to Merner. 'The government is doing all the wrong things, they are considering raising consumption tax, health insurance tax and they are not increasing spending significantly.'
The Japanese economy has no room for fiscal or monetary stimulus because the government has a significant budget deficit so it cannot reduce taxes as a stimulus and interest rates are already near 0%. Smithers says stimulus for the economy has to come from personal consumption or foreign trade.
Savings have been run down because less people are in work due to unemployment and an aging population according to Smithers. He adds that Japanese workers tend to save their bonuses while they spend their contractual income however because of the depressed economy, bonuses have been falling. As a result, consumption is more likely to act as a stabilising factor for the Japanese economy rather than provide a springboard for the economy.
Japan is therefore relying on exports to give its economy a boost. The positive news from the US has been well received by the market but Smithers warns that exports might not rise as much as expected. Around 55% of Japanese exports are capital goods and although the US is going through a recovery, there is still excess capacity in the region, so there might not be strong demand for capital goods. It is the banking sector that is at the heart of the country's woes according to Burghart. 'The problem with the banking system is the underperforming loans. No one knows, including the banks themselves, the extent of these loans.' he says.
Bad debts were first a problem in the property market but successive recessions ensured the problem spread to many other industries. Restructuring in some banks has been dramatic, like in some cases the government has nationalised banks, while other big banks are trying to stay afloat. A lot depends on how the economy does and whether the banks get any help from the government.'
Japan's economic situation does not have an immediate remedy. More reforms need to be pushed through so that there is a sustainable market rally backed by an economic recovery. However the political situation is holding the country back and real reforms are slow to materialise.
The ruling Liberal Democratic Party is having a presidential election in September this year but both Burghart and Merner predict Koizumi will be re-elected as president of the party and will stay prime minister of the country because there are no suitable contender to take his place. While the same political leadership and structural problems are in place it is uncertain how far the current rally can keep going.
Japanese economy still needs significant restructuring and the government does not appear able to carry it through.
Valuations on many companies have become attractive after years of falling markets.
Foreign investors have been realigning their portfolios to move away from previously underweight positions.
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