The first half of the year was an uncomfortable time for investors in the Japanese stock market, irr...
The first half of the year was an uncomfortable time for investors in the Japanese stock market, irrespective of what size companies they chose to put their money in. First, they had to contend with news of an investigation into Livedoor, the internet services company, which led to a sharp fall in equities in January. Then, having recovered from this setback, the market suffered an even bigger fall in May and June when it felt the full impact of the global sell-off in equities.
This was principally driven by global fears about inflation and rising interest rates. Moreover, the stock market falls in Asian emerging markets were particularly severe, with a knock-on effect in Japan.
Towards the end of June, Japanese equities enjoyed a brief rally, encouraged by a positive interpretation of the US Federal Reserve's latest views on interest rates. But the Nikkei 225 still ended the second quarter down 9.1%.
At an individual stock level a gap began to open up in terms of the performance of small-cap companies compared with their larger relatives. In short, small-cap companies suffered widespread falls over the first six months of 2006 as investors sought the relative safety of large-cap stocks. So what is the general outlook for the Japanese stock market and will the performance differential between small- and large-cap stocks persist?
It is worth reminding oneself of the enormous changes that have taken place in the Japanese economy over the last few years. Indeed, this has been the longest period of sustained economic improvement since 1990, with wages rising, property and employment all improving.
The deflationary environment, which has stifled growth for over a decade, also finally seems to be ending with the Bank of Japan increasing interest rates for the first time in six years in mid-July to 0.25%. Meanwhile an intensive period of corporate restructuring has left corporate management with leaner companies and a much more outward looking approach.
A transformation in the attitudes of both individuals and institutions towards equity is also taking place, which is a positive development for the stock market.
Set against this backdrop, we believe we have entered a structural bull market that could last for several years. Of course, we have recently experienced a correction, but the Nikkei 225 rose over 20% in the six months to the end of March, and after such a steep rise some sort of market correction was inevitable.
So what about the difference in performance between small and large-cap companies? We continue to favour smaller growth companies, especially within the retail and services sectors, as they are most likely to benefit from the major structural shift occurring from old-style manufacturing companies to smaller, service-oriented businesses.
Indeed, the valuations of many large-cap stocks are now looking very stretched, particularly since the recent 'flight to quality', and while it is always difficult to pinpoint exactly what will lead to a turnaround in investor sentiment in favour of small-cap, we believe a stronger yen will undoubtedly play a significant part in this process since this will have a negative impact on blue-chip export companies.
And in another development supportive of smaller companies, news recently emerged that Japanese pension funds may soon be allowed to invest in companies outside of the stocks listed on the Tokyo Stock Exchange's first section, which principally consists of large-cap companies. If this occurs, they are likely to turn their attention to small and medium-sized companies.
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