Despite Japan's failure to set the world alight throughout several recovery cycles, things are changing - the political barriers to reform are crumbling, the banking system is over the worst, and Cino-Japanese trade is flourishing
No doubt the first impression of an article on Japan is the same old story about the new rising sun. The problem is, the drum of this scenario has been played so many times in the last two decades and it is very hard to get engrossed.
The key overlooked survey released towards the end of March still showed Japanese land prices declining year-on-year, no surprise as the trend is well established. However, the magnitude of the fall was the smallest in four years and the prices actually rose in certain metropolitan areas around Tokyo. The last time land values were at this level was during the mid-1980s. Now, the vast implications for asset-reflation cycle will have a far-reaching effect on any company with tracts of land in the corresponding areas. An assortment of countries are still benefiting from this theme around the world and the case becomes encouraging for Japan.
While it is undoubtedly true that economic cycles have a profound impact on stock market returns, we have always found it the case when looking at Japan, that it is also necessary to keep an eye on politics. Japanese politics is closely inter-related to the fortunes of the stock market. One only has to look at the progress - sometimes very leisurely - made over the recent years by the maverick Prime Minister Koizumi. Against a background of a country steeped in custom and traditions as well as mature LDP (the Liberal Democratic Party of Japan) members, the leader has managed to forge ahead. The simple election of Koizumi had signalled a change of guard on the political front.
The banking system
Perhaps the most important but clearest example of this has been the changing attitude of politicians towards Japanese banks over the past 10 years or so. As a result of the bursting of Japan's real estate and financial bubble at the end of the 1980s, Japanese banks were left with a debt mountain few in the political classes were prepared to acknowledge, let alone deal with. Why was this important from a stock market perspective? Well, a dysfunctional banking system, where banks were unable and not prepared to make any new loans, significantly shortens the growth phase of the economic cycle. This is because firms are unable to access the banking system for capital to expand production capacity. Thus, we saw shortened economic cycles in Japan throughout the 1990s, resulting in a bear market for Japanese equities during the time when Western markets experienced one of the most explosive bull markets in history. This was Japan's lost decade.
So have we seen any change over the last few years? The answer to that is certainly yes. Even though there were half-hearted attempts to fix the banking system in the later part of the 1990s, it was not until the election of Koizumi that we have seen real change. Without going into the finer points of a torturous couple of years, the country has finally reached a point where it can say with a high degree of confidence that the worst is past for Japanese banks. Stock markets, being forward-looking by nature, have marked up the stock prices of the banking sector by many hundreds of percent since mid-2003 and have led the general recovery in Japanese equities ever since.
old politics vs new
On the face of it, we have recently been witnessing a quiet time on the political front in Tokyo. However, this masks two potentially profound changes which have been bubbling beneath the surface. Firstly is the normalisation of Japan's relationship with the rest of the world. By this, we mean an end to the post-1945 doctrine of the US looking after Japan's security needs. We won't dwell on this important issue here but we are starting to see a more assertive Japan on the international scene - there are Japanese troops in Iraq. While this may appear to be a sop to the US, key constitutional changes were made to be able to send troops overseas, which have effectively opened the door to a more forceful, rather than pacifist foreign policy.
The other main issue, which is perhaps more interesting to equity investors, is the continuing battle between Koizumi and the LDP old guard. Koizumi has undoubtedly pushed through a number of reforms during his tenure but there remain several key issues which need resolving which have profound long-term socio-economic implications. Principal among these is the necessity for radical political change - the breaking up of the LDP - so we finally see meaningful reform of the pension system. Among both the electorate and corporate Japan, this is the paramount issue, where a rapidly greying population is putting huge strains on the current outdated pension systems. Obviously any meaningful reform here has enormous stock market implications.
Enter centre stage the Japan Post Privatisation Bill. This old chestnut has been bounced around for many years now, but finally a tightly scheduled timetable has been set under the direction of Koizumi in order to forge ahead with the bill. In turn, the cabinet is expected to confront the LDP over its final position on the bill next week. If the LDP fails to capitulate over its stalling stance on the bill, then the Cabinet would table the bill in the Diet. The end result will be a cabinet/LDP split, which would be revolutionary for Japan, and would go a long way to moving up reform. It might be destabilising short term, but definitely beneficial to the market in the long term. In summary, the pace of political reform appears to be moving even faster than expected.
Granted, the recent economic data for Japan has been somewhat mixed and in turn proved the sceptics right in the short term. The improvement in the credit data released over the summer provided a glimmer of hope that things have finally changed. Subsequently, the data has failed to improve and actually fell from October to January, undoing last year's gains. Despite positive news flows from the banks, the statistics indicate the credit environment is back to the level it was 12 months ago. As mentioned before, the Japanese market is very much dictated by the cycles in the domestic economy and no doubt the cycle will change for the better. One only has to point to the healthy position of the many regional banks to gauge an improving domestic banking environment.
Spring wage growth is expected to be positive for the first time in years, reflecting better corporate profits and company performances. Corporate Japan is finally beginning to take a more shareholder-friendly approach as dividends and payout ratios are increased. News of increased takeover activity has also helped sentiment among shareholders. There has been the brilliant performance, financially as well as the share price, of the small to medium companies benefiting from the resurgence of the domestic market. The key long-term economic indicators point to an improvement, sometimes volatile month on month, but much more importantly a gradual expansion.
The second macro driver to Japan is the export-orientated companies benefiting from brisk sales in China, the Middle East and the rest of Asia. Understandably, the Chinese government has done its best to cool credit growth and fixed-asset investment in order to curb the pace of domestic development. In turn, the cooling measures have had a knock-on affect to the industries directly benefiting from the growth. One would expect the growth to pick up again in the long term and as a result profit these companies, bearing in mind China is now Japan's biggest trading partner. The key ingredient, as always, with export-orientated companies has been the currency levels and recently the yen has weakened to their benefit.
In conclusion, the sentiment has swung between positive and negative so many times in the last couple of decades, making investors demented over Japan. Many have become fixated on watching monthly economic data and in the process missed the excellent performance of the regional banks, small-cap stocks and many other themes off the radar. In many ways, investors are unable to see the wood for the trees. Without a doubt, the Japanese path out of deflation and the financial meltdown has not been a smooth one and there appear to be many more obstacles ahead. Clearly, many international investors will need 100% proof of an economy and stock market entering a new bull market, at which time the first phase will have already been successfully completed.
The changing attitude of politicians towards Japanese banks has led to a turnaround in fortune - the worst is now past.
The battle between Prime Minister Koizumi and the old guard in the LDP is set to reach a head. If the power of the LDP is broken, a big obstacle to reform will gone.
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