Increased unemployment in Japan means employment agencies, discount retailers and amusement arcades offer good opportunities for investors, while the nation as a whole is showing signs of a sustainable recovery
Is the sun rising in Japan after a decade of false dawns? The 27% jump in the Topix index from the March/April lows through to the first week of July is indicative of a brightening horizon.
With the index having languished below the 800 level for most of March and April, the surge in the market towards the 1,000 level in early July was in part driven by the improving outlook for the US economy as war in Iraq more-or-less ended. A key catalyst to the transformation in investor sentiment however was the partial nationalisation of Japan's fifth largest bank, Resona, in May and the massive increase in the monetary base since the appointment of the new governor of the Bank of Japan (BOJ) last March. These moves underscored the serious reflationary efforts that are being undertaken in Japan to end a decade of stagnation, welcome news for equity investors.
The dire situation of the Japanese banking sector, which has hamstrung the economy for the past decade, is showing signs of stabilisation. For the fiscal year 2002, Japanese banks' non-performing loans (NPLs) declined by 18% suggesting that the bad-loan clean-up is accelerating.
And while NPLs still represented a hefty 8.5% of total debt outstanding, this improvement coupled with other recent financial reform measures and budding signs of an upswing in economic growth suggest strains within the banking sector are lessening.
Bank credit, which has contracted for several years, could finally turn the corner helping to revive capital investment. The recent improvement in corporate profitability and business confidence are supportive while June's Tankan survey forecasting a 4.9% recovery in large firms' capital expenditures.
Notably, however, the majority of signs of an upturn in growth stem from the industrial side of the economy rather than the consumer side. In the first quarter of 2003, real GDP grew by 2.6%. Another encouraging sign is that industrial production has picked up sharply in recent months suggesting a second quarter of respectable growth. Machinery orders excluding electric power and shipping have been positive on a year-on-year basis for the past six months with much of this growth being propelled by foreign demand, especially China.
This also reflects the success the authorities have had in halting a rise in the yen through massive intervention in the currency markets. External demand therefore, as has been the case in all mini recoveries since the collapse of the Japanese bubble economy in the late 1980s, is playing a key role in lifting the economy out of recession.
So should we be more positive about growth gaining traction in the broader economy? The recovery in corporate profitability has been driven by job and wage cuts over recent years with consumers having financed spending by dipping into savings. However, even on the employment front there are tentative signs of improvement with the number of job-holders rising for the first time in more than two years in May.
Moreover, wages have risen lately and large firms are planning to increase summer bonuses by an average of 4.3% this year. So prospects for an improvement in final demand also appear to be on the cards.
Despite all these positive factors, the market rally has stalled in recent weeks below the 1,000 level. Analysis of market performance shows that small cap stocks and low-priced stocks have delivered the best performance this year. A less well-known factor is that the low-point in this segment of the market and among medium cap stocks actually occurred on 12 December last year whereas the low-point for the overall Topix index occurred on 11 March this year, followed by the Topix Large index in late April.
This is in keeping with typical trends in the Japanese market, with Japanese stocks often lagging the US market by several months. Moreover, higher beta stocks drove the US market higher from its trough last October. In turn the Topix Small index and the Topix Medium indices, have tended to take their lead from the performance of higher beta, cyclical stocks in the US.
Further analysis shows that the pool of low-priced issues has expanded greatly in recent years. Companies have decreased the nominal value of their shares in order to entice individual investors. A closer look at inflows into the equity market suggests domestic speculative traders and hedge funds have been the predominant buyers of these types of stocks.
Perhaps more well known is the fact that foreign investors have been net purchasers of stocks in recent months and have been a key driving force in moving large cap stocks higher from the March/April lows. Foreign investors generally favour blue-chip international names. Although the scale of their net purchases has shown signs of slowing in the past couple of weeks, we expect demand from foreigners to continue over the medium term, especially given that exposure to Japanese equities by foreign investors has been at extremely low levels for an extensive period.
Essentially, domestic institutional demand has been largely absent during the recent rally. In the near term, selling pressure from this source will continue and because of this fact it is difficult to say with any degree of certainty that we have seen a secular bottom to the decade-long equity bear market.
The key selling pressures from institutional investors are the requirement for pension funds to return their proxy portions back to the Government by the end of September and the ongoing cross-shareholding liquidations from the four main Japanese banks. Within the April to June quarter, the four major banks achieved around 30% of their full fiscal year liquidation targets. Cross-shareholdings have now reached levels not seen since the 1950s. This was when the practice began in earnest, giving room for optimism that we are close to an end-point.
Moreover, offsetting this selling pressure is the Government stock-purchasing entity, which as of the end of August, due to a recent change in the law, will have the 8% fee for transactions abolished, giving further support to the market thereafter. On the face of it, supply pressure appears to be waning. So has daybreak actually arrived? The excesses of the 1980's bubble economy have taken years to work off. As such, we do not expect risk taking to increase quickly.
For the overall market to make further headway we require demand from domestic institutions and finally retail investors. Key to inflows from these participants, however, will be evidence of a sustained improvement in earnings and here signs are also increasingly positive.
Indeed, fine-tuning your sight on specific areas, especially, those parts of the economy that are benefiting from long-term structural change, one can find that earnings trends are positively dazzling. We target companies benefiting from outsourcing trends, the decline in Japanese job-for-life trends and increased leisure time such as employment agencies, amusement arcade operators and, as a result of redundancies and pressure on wages, the rise in discount retailers.
Many of these companies exhibit strong earnings trends and cashflows but are significantly undervalued relative to their growth rates. As investors begin to focus on company fundamentals as the market moves into its earnings-oriented phase, companies exhibiting sustained earnings such are likely to be favoured. After a decade of false dawns, maybe sunnier times finally beckon.
There are good opportunities in sectors of the market that can benefit from long-term structural change
Foreign investors have been net purchasers of stocks in recent months and have been a key driving force in moving large cap stocks higher
The Japanese banking sector is showing signs of recovery with a drop in the number of NPLs
Both industrial and consumer sides of the economy are showing encouraging signs of growth
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