Foundations still shaky
When we focused on Japan back in April the mood was very much that this latest recovery was not the traditional flash in the pan but something more sustainable. But is it?
First the good news: The stock market is still moving ahead strongly, although it will not achieve the 40% return of last year, the highest return since 1973. “The market cannot continue going up at that rate,” says Stephen Mitchell, fund manager at JP Morgan Fleming Japanese Investment Trust.
The consensus is that the market will grow in line with corporate earnings, which are forecast to increase by 15%. Some are more bullish about earnings: “From company interviews we have done we think 15% is a bit cautious,” says Mitchell. “They have factored in issues like Iraq, an increase in US interest rates, an oil price rise and a cooling of the Chinese economy.”
So have they overreacted to these factors? “Yes,” says Mitchell. “I think we could see a 20% rise in earnings over the next 12 months.”
Meanwhile Brendan Brown, head of economic research at the London office of Tokyo-Mitsubishi International counsels caution: “In the last year or two China has contributed about 80% to export growth. Clearly the exporters are going to be vulnerable to the Chinese economy and to a possible US slowdown, so my preference would be for more domestic-dependent stocks. Some of the bombed out values in the retail sector would do well from an increase in consumer spending.”
The Chinese economy, the great regional growth engine, has been overheating. “They are deliberately cooling their economy while they deal with capacity bottlenecks,” notes Mitchell.
But in dealing with the bottlenecks China is providing further opportunities. “If you are supplying turbines for power stations your business is accelerating,” says Mitchell; “if you are supplying cranes to move containers round ports demand is fantastic.”
He adds: “another sector we like is steel. All of the auto factories that are built in China have to buy the steel sheets from Japan these will have a huge area of good growth.”
Japan is also benefiting from the commodity boom: the trading companies have got big investments in iron ore coking coal and gas.
Shipping companies are another area with potential. “As China and the US import more energy it is good news for Japan’s shipping and shipbuilding sectors.”
But while Japan still appears to offer potential for investors, the big question of sustainability divides opinions.
Leslie Jones, head of global markets at Old Mutual Asset Managers points out that “at the long end bonds have appreciated and the yield curve has steepened suggesting that the bond market thinks that there is some recovery on the way.” He adds: “There are also definite signs of pickup in property market which is a very good sign for economy.”
The news on banks is very mixed. Stocks have performed well but the underlying fundamentals are not sound. Richard Brooke, Director of Brooke Research, highlights the example of UFJ, Japan’s fourth- largest bank. “UFJ has been hauled over the coals for lying about its bad loans. This is a classic demonstration of why it is too early to say that the banking crisis is over.”
He adds: “We need to see evidence that established habits of practice have changed. I see some big demonstrations that they haven’t changed in the banking industry, the private sector and the government sector. There is worse to come for the UFJ price; this makes me concerned about what is in store for the rest of the economy.”
Brooke points to the changes that need to take place in the Japanese economy: a falling deficit turning at least into a primary surplus, a fall in bond issuance as a percentage of spending and in debt service as a proportion of tax revenue. “None of these things are happening,” he says; “quite the reverse. This makes me very suspicious about the strength of the Japanese recovery.”
The news on interest rates does not brighten the picture. “In any event rates are going to be held at zero for two years or more,” says Brown of Tokyo-Mitsubishi International. He notes that “the Bank of Japan’s priority is to eradicate deflation, but they have a long way to go. Productivity growth has actually accelerated so wage costs are falling substantially. Other than oil prices going up, there isn’t really much basis for a return of inflation.”
We’re not out of the woods yet, then. Far from it.