The Bank of Japan announced in July a recovery is imminent and corporate earnings are expected to pi...
The Bank of Japan announced in July a recovery is imminent and corporate earnings are expected to pick up by the end of the year. This recovery is threatened by falling investor confidence in the US and a falling dollar.
'There is enough evidence the economy's cycle is turning around,' says Kevin Gibson, head of the Japan desk at Edinburgh Fund Managers. 'Industrial production is recovering, demand and exports are rising and inventories are at record high levels.'
Japan's economy is sensitive to the global market and at a time when the US market is falling, Japanese companies may experience depreciating valuations.
John Greenhill, Japanese investment manager at Royal & SunAlliance, says: 'Foreign investors are a big part of Japan's market and as sentiment is down, the Japanese market will be affected in that the valuation of Japanese companies may fall.'
Gibson argues a fall in international markets will not make its mark on the overall Japanese economy unless it is sustained for a long time. He says: 'On a currency adjusted basis the Japanese stock market is up year to date while the Nasdaq fell 29%.'
A second factor that causes concern is the fall of the dollar, which in turn strengthens the yen and makes Japanese exports relatively less competitive.
'The weakening of the dollar renders Japanese exports more expensive,' explains Gibson. 'Japanese exports have not been affected by the recent fall in the dollar but we are monitoring currency movements.'
Despite Japan's recovery, there is a dissatisfaction as to the reforms carried out by the prime minister Koizumi.
'Governments never move at the speed that the financial market wants them to move,' comments Greenhill. 'We did not expect as much as the market, in terms of reform, when Koizumi came into power but we were nevertheless disappointed.'
However Gibson says changes are slowly taking place within the economy. 'When the prime minister came into office, investor expectation for change was high, but they were soon disappointed with the lack of reforms. But gradually changes are happening and we are seeing the results.'
The worst-affected sector of the economy is the banking sector. The sector is debt ridden and the prime minister has stated the government will not aid the sector in any way.
'Most Japanese companies have a solid balance sheet,' says Greenhill. 'The banking sector though is besieged with bad debts. Although we've seen some progress, the bad debt situation remains a problem area.When growth starts to pick up, the government will have to intervene and bail the banking sector out.'
fund manager comment: Standard Life
With global equity markets still feeling the hangover of the TMT bubble all eyes are on the East, wondering if Japan will shake off the effects of its own bubble that burst 12 years ago.
The future looked brighter in April last year when Prime Minister Koizumi promised a programme of aggressive structural reforms. He has struggled to break the resistance of the many vested interest groups in Japan and now, he has missed his window of opportunity. While this casts doubts on the long-term outlook, the good news is the world's second biggest economy may be recovering slowly.
While Japan is still dependent on overseas demand, there are signs that the recent surge in exports is feeding through to the domestic economy. Machinery orders, a good leading indicator of capital spending, rose in April and May. Meanwhile, the consumer has been surprisingly firm recently, despite falling real wages and rising unemployment. The recent appreciation of the yen against the dollar is naturally seen as a risk to this nascent recovery.
The operational gearing of corporate Japan remains relatively high, so even a lacklustre economic recovery can lead to significant profit growth. There are also signs some major companies are starting to reap the benefits of restructuring. Major industrial electronic companies like NEC, Fujitsu, Hitachi and Toshiba are expected to announce results for the April-June quarter above expectations as headcount reductions, plant closures and divestments improve profitability. The combination of a recovering economy and improved corporate efficiency could result in a sharp rise in profitability.
Nevertheless, there are risks to any upbeat scenario. The domestic demand recovery is fragile and the banks are still mired in bad debts. There are also worries that the accounting scandals in the US may spread to other regions.
Robert McKillop is head of Japanese Equities at Standard Life Investments
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