Despite the Japanese government's much-heralded package of fiscal stimuli, and claims by certain analysts that Japan could be the next great trade, the current rebound is likely to be no more than another bear market rally. The reasoning be-hind this is threefold: unless there is evidence of the pursuit of a genuine bad debt workout, aggressive corporate restructuring, or more compelling valuations, liquidity alone will be unable to drive a sustainable rally.
Kathy Matsui of Goldman Sachs' Tokyo office feels that the Nikkei's recent rebound is very reminiscent of the bear market rally in July. At that time the key factors driving the short-lived rally included financial sector reforms, more fiscal stimulus and a perception that Japanese eq-uities were undervalued, which triggered heavy foreign inflows," she points out, adding that these are almost identical to the background influences to the current rally. In the month following the early October low global equity prices rose by 17%, but this figure was outstripped by Japanese equities which went up 29% over the same period.
Matsui advises investors with a medium-term horizon to emphasise defensive sectors and balance sheet quality in stock selection. "The reasoning behind this is that while we are assuming a medium-term bullish stance on the stock market, the hard landing has not yet begun, and when it comes the downside risk on many economically-sensitive stocks is likely to be very substantial. Given the recent pullback of many defensive stocks, we believe there is an excellent opportunity to accumulate some of our favourite stocks such as MEI, Murata, Bridgestone, Hitachi Software, Ines and Kirin Beverage," says Matsui.
Most UK and European-based portfolio managers are extremely underweight in Japanese equities, relative to their respective benchmarks. With rock-bottom weightings, and the rest of the world's equity markets ap-pearing less attractive now, it seems logical that the next step in Japanese allocations will be up rather than down. The question remains, however, when and what will be the catalyst. The answer will surely depend upon just when Matsui's 'hard landing' take place, and that of course is the million-dollar question. Her answer is to watch unemployment statistics. "The un-conditional injection of liquidity from households to in-debted corporations will continue until unemployment spirals upwards. This will mark the beginning of our 'hard landing' scenario."
The other major influence on performance at the mo-ment is the strength of the yen. "Apart from the banking sector we can think of very few reasons why a strong yen is good," says Matsui. "We estimate that a 1% move in the exchange rate affects profits by roughly 4-5%; therefore if the currency were to average ¥120, RP would decline by approximately 20-25% in-stead of our current forecast of 13%. Consequently ex-porters such as Pioneer, Maz-da, Sharp, Nissan and Mitsubishi Motors, as well as the metal industries, will be se-verely affected. For importers the perceived benefits are like-ly to be smaller than the actual merits, as lower costs are offset by the impact of deflation on revenue growth."
John Charlton Jones at HSBC Investment Bank in London confirms that his company's analysts in Japan broadly agree with a defensive strategy, and are equally sceptical about the government's interventions and their likely effect. "We remain defensive, with main overweights in utilities and railways, and have increased weightings in autos, where we think the worst of the bad news is over," he said.
He does not believe that the injection of public funds into the banks will change anything, unless it is accompanied by mergers and cost cutting, and a reduction in capacity. "Given that the government is promising that if the big banks apply for money, they will not be re-quired to swallow any bitter medicine, none of these outcomes seems likely."
Yet, despite their bearishness, HSBC analysts do not subscribe to the meltdown theory. They remain concerned, however, that some elements within the government are considering capital controls or restrictions on foreign equity investment - for example, requiring investors to deposit an amount equal to their investment for a fixed period of time. "Although we think it is highly unlikely that anything like this will happen, it is frightening that the authorities are going so far as to conduct feasibility studies into such measures."
He points out that, despite a bottoming of bond yields, the dividend yield ratio still makes stocks look attractive versus bonds. But finding a sensible measure on which to value Japanese equities is getting harder. HSBC's top-down numbers are forecasting negative earnings this term (if financials are included), so the prospective PE ratio is meaningless. Price/book measures also seem unreliable in an environment where book value cannot be trusted. "This means one has to fall back on the dividend yield. With the dividend yield consistently higher than the yield on the government 10-year benchmark over the past two months, this has provided some support for the market. Individual investors have noticeably been net buyers of equities since August, partly because of this."
Although dividends are likely to decline a little over the next three months, dividend yield remains the one compelling reason to buy Japanese stocks, but the bottom line seems to be that fiscal and monetary stimuli will only work if they are accompanied by a genuine bad debt workout process. Kevin Hall"
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