While considerable slack remains in the Japanese economy, there are also strong signs of sustainable recovery as years of corporate restructuring start to pay dividends.
So first the bad news: in its most recent monthly Report of Recent Economic Developments published in February, the Bank of Japan (BOJ) commented that consumer prices “are basically projected to continue falling slightly, since the imbalance between supply and demand still remains considerable despite its gradual improvement.”
With this backdrop, there is unlikely to be any stirring on the interest rate front. “We’re not expecting the bank to change its zero interest rate policy this year,” says Denis Clough, fund manager of Japanese equities at Schroders. “They’re still worried about deflation so they won’t tighten policy for at least a couple of years.”
But the slack appears to be diminishing. In a research report published last month, Merrill Lynch presented an upbeat prognosis: “With more companies looking for more employees than ever before in Japan’s economic history, a full-fledged consumer demand recovery cannot be far off, in our view.”
Much has been made of the role played by China and, to a lesser extent, the US in driving Japan’s recovery. “I am very reluctant to push the China argument,” says Guy de Tonquedec, Portfolio Manager at Credit Agricole Asset Management. He feels that growth in both economies will slow significantly next year, and that the driver of any recovery will come from home. “The domestic economy is doing surprisingly well,” he says. “Land prices are getting back to their pre-bubble levels.”
He adds: “For the first time in 10 years, the market is rising in the absence of any government budget stimulus.”
Corporate performance is improving strongly. “The amount of restructuring that has gone on is finally beginning to bear fruit, says de Tonquedec. “The balance sheets are beginning to look extremely sound; the cash flows are spectacular, and returns on equities, having been in the doldrums for many years, are rising very fast, although admittedly from a very low base.”
The outlook seems bright indeed: “we are optimistic about profits growth for this year and next year,” says Clough of Schroders.
In some areas the scale of the restructuring has been staggering. “The banks, which had been the laughing stock of the investor world did so much cleaning up that you can actually begin to value them properly,” says de Tonquedec. “Over the past six or seven years, the number of non-performing loans that were cleaned up is equivalent to 18% of GDP. It is mind-boggling.”
He adds: “Until last April you had to have guts to buy into a Japanese bank. Now we are happy to have an overweight on the banking sector.”
In terms of sectors which may outperform, the focus is domestic: “Like everyone else we are excited about the property sector,” says de Tonquedec. “In certain transport companies we are seeing some pricing power creeping back in. Retail is our favourite sector for this year.”
Clough points out that last year the emphasis was on recovery, so the blue chip stable performing defensive stocks performed very poorly even though market was quite strong. He also shares the enthusiasm for transport: “This year we favour the railway companies and pharmaceuticals which are more stable and generate free cash flow.”
Meanwhile, the small cap opportunity seems to be past its best. “Small caps have outperformed large caps very strongly over the last three years,” says de Tonquedec. “I think this is coming to an end; the valuation gap has narrowed.” He adds: “If people are going to start believing that Japan is not dead in the water they’re not going to buy the small fry.”
Equities are cheap, says Merrill Lynch in its report. “The last time the Nikkei 225 was at 11,000 was in early 1985. Then, Japan’s GDP was ¥350trn; today it is ¥500tn (E3.65tn). Concurrently, corporate profits have risen steadily, exceeding bubble-economy highs.”
The general sentiment is that the Nikkei will perform very well this year. Says de Tonquedec: “I expect the Nikkei to increase in line with earnings growth of 15-20% both this year and next.” Meanwhile Clough of Schroders is slightly more cautious, with a prognosis of 10 to 15% growth in the Nikkei this year.