Value in Japan
The ups and downs of market sentiment. Feelings about the Japanese economy vary considerably. Opportunities are there but the underlying fundamentals remain uncertain.
Beyond doubt is the considerable slack that remains in the system. “We don’t think that the bank of Japan will raise short term rates for quite a while,” says Natasha Chetwynd, head of Japanese equities at Britannic Asset Management.
“The consumer prices index is still at or below zero and the bank of Japan has said that until it is 1% or so above zero it won’t tighten monetary policy.”
She believes it will be 12 to 18 months before rates are increased. “It depends on what happens globally,” she continues. “People aren’t too sure as to whether the global economy is on the point of peaking or whether it’s going to continue to grow very well.
Dresdner Kleinwort Wasserstein (DKW) is downbeat about prospects for the Japanese economy. In its most recent Global Equity Strategy report entitled ‘Too much enthusiasm for Japan’ it expresses doubt about the sustainability of the rally of the Japanese market. In respect of the prospects for growth in industrial production for example the report notes: “Recent weak economic news has generally been treated with disregard by the market.”
In spite of this the sentiment is that there is much good value in the Japanese equity market at present. In its October Japan Strategy Flash Goldman Sachs notes that “as a result of continued robust earnings momentum and sluggish stock prices, valuations are now more attractive than at any point this year.”
Since our economists do not expect any BoJ tightening until the latter half of 2006, we believe that Japanese valuations remain attractive, particularly given the low interest rate backdrop.”
The Goldman Sachs report anticipates soft landings in China and for the most of the rest of the world in 2005. “We maintain our overweight positions in global cyclical areas such as basic industries, capital goods, trading/wholesale, and transportation,” the report says.
“Meanwhile, with respect to domestic-oriented sectors, we also remain overweight in infrastructure-related as well as financials.”
Britannic notes that the banks have more growth potential. “The bad loan problem is close to being resolved,” says Chetwynd. “Bankruptcies are down 40% compared to last year which is partly due to a better economy and also because the banks have dealt with a lot of the bad loan problems.”
Sectors fuelled by the growth of the Chinese economy have started to lose their shine. “We were overweight until August when we started selling the steel stocks and more recently we have been selling chemicals stocks,” says Chetwynd; “they have done so well that we think a lot of it is in the price.”
She adds: “The area that we are most overweight in at the moment is domestic reflation beneficiaries, namely banking, construction and retail. We think this is a story that can run for several years rather than being short term. It is also where we see many of the cheaper stocks in the market.”
He adds: “When short term interest rates rise it will be another reason to invest in banks. They are the main beneficiaries because they can start to make money from their large deposit base.”
Britannic has also been increasing its exposure to technology related areas of the market on the basis that while the demand outlook is good, stocks have been performing extremely poorly because people thought they were overvalued, so they were no longer on such a big premium.”
Meanwhile Goldman Sachs remains slightly underweight in technology.
“We are also underweight defensives such as pharmaceuticals and food – both of which have outperformed the market to date,” its report notes.
The report suggests that the TOPIX could test the year’s high of 1,217 by year-end, citing the fact that “much of the negative macro news on slower growth and higher oil prices appears to be discounted, the positive news from interim earnings results and seasonal foreign inflows.”
Chetwynd agrees that this is achievable. “The US election and the oil price could effect sentiment although I don’t think they will have a big impact ultimately on what Japanese corporates do.”
DKW pours cold water on the optimism. “Japanese earnings have been remarkably cyclical in the aftermath of the bubble bursting. It is always possible that ‘this time is different’ and that the profits cycle will decouple from the economic cycle.
However, it requires a leap of faith on the part of investors, something we are not comfortable with. In addition, the sheer scale of the earnings upswing is highly suggestive of massive operational leverage, good news into upswings but seriously bad news into downswings.”