Fund managers have been negative towards Japanese equities for a long time. However, since last year, they have started to change their tune and begun to rethink their negative bias as the outlook turns more positive
Economic data in recent months confirms that the Japanese economy is turning the corner. During the final quarter of 2003, nominal GDP growth of 6.4% at an annualised rate was recorded compared with the third quarter, with industrial production rising at its strongest pace for five years. Although inventories unexpectedly declined, production should be positive in 2004.
Despite expectations that economic growth in China and the US may slow slightly this year relative to 2003, growth in these countries is likely to remain at above-trend levels. This will continue to be positive for export volume in 2004 and 2005, and to feed through to manufacturing. Over the long term, demand from China is likely to be an important source of economic growth in Japan.
In terms of the domestic economy, housing market indicators are improving, including figures for land prices survey, housing starts and apartment sales. This is providing another indication that the domestic economic recovery is finally emerging and that the Japanese are gaining in optimism, retail sales are picking up; in January retail sales climbed 4.5%.
In addition, new job creations are rising and this is cushioning the effect of job cuts made by companies during restructuring drives. Underlining the new confidence in the recovery, domestic institutions have implemented asset allocation changes, shifting money out of Japanese government bonds into real estate investment trusts (Reits) and corporate bonds and even equities in some instances. There will be continuing improvements in the housing market and in domestic consumption in 2004 as the economic background and confidence strengthen further.
For many years, deflation has been at the heart of Japan's economic woes. However, since December, the rate of deflation has been flat. It would not be surprising to see deflation fall to zero and inflation return to Japan, albeit at low levels, by 2005. The primary drivers of this would be rising land and housing prices, and higher commodity prices. Consumer goods prices should be at least stable.
These domestic improvements are significant - in previous economic upturns in Japan in the past 15 years, domestic improvements have been negligible or completely lacking and any strengthening in conditions had been led by rising external demand. The Bank of Japan (BoJ) is unlikely to tighten monetary policy during 2004, as it is keen to foster a reflationary and accommodative background for the economy. The BoJ has also ensured that liquidity levels are high, primarily by selling yen to prevent yen strength from hurting exporters, and this looks set to provide another boost to the Japanese economy.
For some years, banks have been unwilling to lend money, which has meant that the liquidity pumped into the economy by the BoJ has failed to feed through to broad based economic improvements. However, banks are now trying to increase their lending activities by targeting small- and medium-sized companies, and are also trying to tap into consumer finance opportunities. Overall, the outlook for the Japanese economy is brighter than it has been for some years. Growth is expected to be at around 3% in 2004. Although the really important number is nominal GDP, given the potential double booster from rising economy and turn around in GDP deflator.
The outlook for Japan has been upgraded during the first quarter of 2004, and fund managers have been increasing their weightings in Japanese equities especially in the financial sector. In addition to expectations that the Japanese economy will strengthen in 2004, there are various other factors that contribute to the more positive view.
Japanese equities are attractively valued relative to historic averages and also relative to other developed market equities. Consensus estimates are for earnings growth of 34% in 2004, and fund managers expect to see earnings growth of around 15% in 2005, with cost cutting expected to be the key driver over the next two years. Many firms are implementing restructuring drives, and companies are generally bullish about their ability to make further cost savings. Of course, cost-cutting cannot continue ad infinitum, and by 2005 it will be harder for companies to identify savings. Production capacity has now fallen back to the levels seen 15 years ago. Overall, there is scope for earnings upgrades to be made, particularly given the cautious forecasts that companies are making. This would be positive for share prices.
For some time, the fate of the Japanese equity market has rested with foreign investors; domestic investors were content to hold mostly Japanese government bonds (JGBs) given the economic background and dreary outlook. However, conditions are now right for the market to receive some support domestically. The unwinding of cross-shareholdings by banks, which has placed downward pressure on the market for some time, has now been largely completed.
As already discussed, financial institutions have already begun to sell JGBs in favour of corporate bonds and Reits, and there is plenty of scope for these institutions to allocate more money to equities as confidence grows. JGB yields are very low and unattractive relative to equities. The Japanese government pension fund is also set to increase its weighting to equities this year. Meanwhile, share buy-backs as companies' financial positions improve are anticipated this year, which would also be positive for equity prices.
Overseas institutional buying is likely to help to drive the market upward in 2004. Overall, foreign investors will remain the most important determinants of the Japanese market in 2004, and this leaves Japanese vulnerable to downturns in global investor sentiment. In periods when confidence dips, Japan may struggle to progress. Signs of greater than expected slowdown in economic growth in China or the US could be negative for the market. In addition, a strengthening yen could restrain gains, particularly for export dependent sectors such as the automobile manufacturers.
However, the positive factors will win out. The strengthening Japanese economy, attractive valuations relative to other developed markets and superior prospects for earnings growth should attract buyers, while domestic factors should also provide extra support.
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