The gap between the 'never again' pessimists and the 'this time it's different' optimists remains as wide as ever, with domestic players being on the whole sceptical while overseas managers see the bright side
There are two distinct schools of thought on the outlook for Japanese equities. In one corner stand the optimists, who are mainly overseas fund managers. They argue that 'this time it is different', meaning that the near 60% recovery in the Nikkei 225 index since the end of April 2003 will not go the way of previous rallies during the fourteen-year bear market which started at the end of 1989. In the other corner are the doubters; predominantly domestic fund managers, who have seen it all before and contend that Japan's structural problems have not be solved, only given a cosmetic coat of whitewash. The resolution of these opposing views has huge implications for investors. It is important to examine each piece of evidence presented by the two sides to determine the likely outcome.
According to the Merrill Lynch monthly surveys, the balance of opinion among international fund managers has been moving steadily from scepticism to enthusiasm. This is significant because overseas fund managers, despite owning less than 15% of Japanese shares, typically act as the swing factor in the Tokyo stock market. That was the case during previous rallies, notably those in 1995/1996 and 1998-2000, which saw the Nikkei rise by more than 50% before surrendering all its gains and plunging to new lows in the face of continuing economic decline. Overseas fund managers are currently overweighting Japan in their global portfolios, clearly seeing a much more promising economic and corporate picture than the one that prevailed in the 1990s, often dubbed 'Japan's lost decade'. This is partly Japan-specific and partly a way of playing the global recovery theme. With most fund managers taking a positive global view, but with most of those outside the US continuing to underweight that market in their portfolios, Japan, along with the Pacific Basin and emerging markets, represents the best option. By contrast, domestic institutions (but interestingly not retail savers) continue to take a more cautious view, remaining far from convinced that the current upturn is sustainable. Even in a mildly deflationary environment, domestic government bonds still have attractions. Many locals regard the foreigners as fall guys, blindly creating a bandwagon and viewing all developments uncritically as good news.
On the economic front, the data does indeed look increasing positive. GDP in the final quarter expanded at an annualised rate of over 6%, a trend which the latest Tankan report seems to confirm as continuing into the first quarter of calendar 2004. Growth is being driven mainly by exports, especially to meet the expanding demands of US consumers and the huge appetite in China for capital goods. Large Japanese companies have benefited disproportionately from these influences, which have played a central role in lifting the economy out of recession. Hitherto, the main device used to jumpstart the economy was public spending, often dispensed wastefully and ineffectively on unproductive capital projects. With public sector debt likely to top 140% of GDP the option to pursue this course of action is no longer there. Indeed, cutbacks are now the order of the day. That is a healthier position than in the 1990s, when the dynamic of China was but a dream. There are also indications that economic recovery and rising commodity prices are starting to reduce the rate of deflation, then optimists might even argue that a revival in consumer spending might be on the horizon. Finally, evidence that the long decline in real estate pricing may be drawing to a close suggests that a further major depressant on consumers and on the banking sector might be about to lift. The authorities have, at last, been prepared to take decisive action to deal with bank bad debts, a factor which has triggered the strong performance of shares in that sector. On the face of it there are grounds for hope. Tentative forecasts of GDP growth for 2004 range above 3%, but 2005 is more difficult to call. The key issue is the sustainability of the current recovery.
On the corporate front, too, the news flow has been generally benign. Companies have been busily restructuring their operations, cutting costs and outsourcing some of their activities to China. In this sense, the corporate sector has been much more decisive than the state in carrying through reforms and in maximising opportunities. In particular, China's demand for capital and infrastructure goods has been successfully tapped, with Japanese companies gaining market share at the expense of their European rivals. So much so, that Japan now has a trade surplus with China. With capital spending subdued, cash generation has been impressive and trading margins have been well protected. The financial position of the corporate sector, especially in the case of larger companies, is healthy. Managements are well placed to devote more resources to capital expenditure (a sure sign of their faith in the sustainability of recovery) or, alternatively to step up dividend payouts or buy their own shares. These trends will be closely watched during the coming company results season. Finally, it seems likely that the pace of M&A activity is about to quicken and that private equity groups are eyeing Japan as a suitable base for expansion.
Looking at a range of market fundamentals, the outlook differs in many ways from the pattern prevailing during previous abortive rallies. First, the authorities seem more enlightened and patient in maintaining an accommodative monetary stance. There seems little risk of them repeating past mistakes of raising interest rates prematurely or of imposing tax increases. Secondly, the downward trend in property prices seems to be levelling off. Thirdly, China has replaced public spending as a key stimulant of economic activity. This should be more productive and sustainable in the longer term, although, inevitably, vulnerable to fluctuations. Fourthly, the process of unwinding corporate cross holdings may be slowing. Finally, Japanese equities no longer stand on extravagant valuations, as they did in the 1990s, even after substantial declines from the bullmarket peak. And finally, with corporate earnings likely to grow by 10% or so in the current year, Japanese equity valuations are quite reasonable. While price earnings ratio are similar to those on Wall Street, other valuation measures (e.g. price/book, price to cash flow) are modest by the standards of other western markets. Furthermore, within a very extensive investment universe there are plenty of anomalies, which make the Tokyo market ideal for skilful stock pickers.
However, closer examination of the economic data reveals potential flaws for sceptics to highlight. First, economic recovery has so far been quite narrowly based. Large exporters have done well, but the latest Tankan survey revealed less optimism among medium-sized companies, which is ironic in the light of the exceptionally strong performance of these shares on the stock market. Apparently, there is some evidence of a breakdown in the traditional ties between large groups and their smaller subcontractors, a consequence of more work being outsourced abroad, especially in China, as part of corporate restructuring. There is also less optimism in non-manufacturing areas, reflecting a reluctance by consumers to spend. The anti-deflationary forces, which have already been mentioned, are at risk of being countered by further appreciation in the yen. Having spent record amounts in currency intervention in the first quarter, the Bank of Japan has been persuaded to step back from the market and to play a more limited game. With huge overseas inflows being attracted for the purpose of acquiring Japanese equities and with many of the problems weighing on the dollar set to persist, there is a risk of the yen resuming its upward course. This would make imports cheaper, thereby helping to prolong deflation and ingraining deflationary notions into the psyche of consumers. In addition, unemployment is over 5%, social security taxes are rising and the cost of pensions is continuing to increase.
While the economy is less dependent of stimuli from public spending, this point of vulnerability has been transferred elsewhere. In the absence of sustainable domestic drivers, Japan is predominantly a play on a global cyclical recovery, led by the US and China. Therefore, any setback to either would probably have a disproportionate impact on investor sentiment towards Japan, especially if that continues to be determined mainly by overseas fund managers. It would be highly reassuring if the economy broadened out and that domestic influences played a larger role.
on balance - a positive story
It has been possible to make money from Japanese equities even during the long bear market; by buying into the succession of powerful rallies and noting when the opinion began to shift towards the view that a new upturn is underway. This time around there are more reasons for believing that the prolonged bear trend has ended and that Japan may have become a stockmarket for investors, rather than traders. At present some key elements are missing from the equation that would allow an unambiguous pronouncement of a new upturn to be made. But no bull market ever advanced without overcoming a succession of doubts. While the Tokyo stockmarket is probably due for a phase of consolidation after such a sharp rally, there is still scope for long term investors to make money there. In that sense Japan has returned to the global investment mainstream after many years on the margin.
The balance of opinion among international fund managers has been moving steadily from scepticism to enthusiasm.
Growth is being driven mainly by exports, especially to meet the expanding demands of US consumers.
The corporate sector has been much more decisive than the state in carrying through reforms and in maximising opportunities.
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