Wait for rout to be over
Plagued by serious structural problems, Japan is still a market for only the bravest of investors. Things can’t get much worse, strategists say. But is this necessarily an argument that improvement is on the horizon?
Among the optimistic voices, Mike Collins, chief strategist with Pictet Asset Management in London, says prospects for 2002 in Japan do look a little brighter than they have done in recent years.
“Although the thorny issue of bank reform is still yet to be tackled, with job cuts increasing rapidly, pay settlements coming in below inflation and a weakening yen, the competitive of the Japanese economy is improving,” he says.
Economists agree that the problems in Japan are two-fold. Firstly, the country’s banking sector is practically gridlocked – beset with bad debts and largely unable to make further loans. Secondly, the economy is stuck in the middle of a global downturn.
“Japan is facing a difficult time,” says Matthew Wickens, global economist at ABN AMRO, in London. “Banks have saddled themselves with a lot of bad debt… they aren’t lending and firms don’t want to borrow so the money mechanism really isn’t working.”
In terms of the economic cycle, Japan’s situation is not very different from the rest of the world, says Yukiko Kawamoto, head of equities at HSBC Asset Management in Tokyo. The downturn inventories and industrial production is likely to have bottomed out in November, January and February, she says. “The yen’s depreciation has helped competitiveness, but the benefits of this are limited”, says Wickens.
Kawamoto agrees that the positive impact of the weaker yen is now less marked than it was before. “Everyone has overseas production sites – in China, for example,” she points out.
Deflation is unlikely to abate, with retail prices continuing to fall, predicts Wickens. Political action is needed, but Wickens says: “There does not seem to be sufficient will power in Japan right now to do any more to tackle its problems. Whether or not it is worth investing in Japan right now comes down to your own view on whether there will be significant structural change.
“Our view is that structural reform is not going to be fast enough to warrant getting back into the market. There will have to be a trigger for Japan to get to grips with its economic shortcomings”, he says. But quite what that trigger will be is uncertain.
“There needs to be a cathartic shake out,” says Wickens, noting that in the past economic crises in countries such as Mexico, Russia and Brazil have been dealt with after foreign investors pulled the plug.
In Argentina, however, it was domestic events that sparked the process leading towards reform. This may happen in Japan too, according to Wickens, although it is unclear when domestic residents will feel they have had enough.
Kawamoto acknowledges that the market is behaving as if the Japanese economy is in crisis. But she disputes that things are as bad as all that.
“This is not a crisis,” she says. “Most companies don’t have financial difficulties – most companies do have cash from operations. Current economic conditions mean there is no strong incentive to increase capital expenditure, so many companies don’t have cash problems.”
Neither do smaller companies, she adds. “The small cap market is quite strong compared to large caps.
“The sorry state of the banks’ balance sheets is the real problem,” she continues. “Banks are now writing off their bad debts more aggressively. The major worry is that this will lead to a shortage of capital, particularly for the major banks.”
Richard Cardiff, fund manager at JPMorgan Fleming Asset Management in London, says he believes the next six months will indeed be a risky period for the Japanese market.
“You are likely to see some more bankruptcies as banks can no longer bail out companies,” he says. Kawamoto says it is hard to predict how the market will react if there is a big bankruptcy. Market players will then be looking to see if the government would be willing to step in.
But perhaps the rout will soon be over. Though the economic situation is set to worsen in the first half of this year, Cardiff says this will be very much the endgame.
The Topix index has bottomed out at 1,000, as seen in five previous troughs, says Cardiff. “It is now bumping along the bottom, looking for direction… Direction will be taken in earnings,” he says. The first improvements to come through will be for companies with a large export component to their business.
Cardiff says market players will focus on particular stocks in the next few months, specifically companies with strong balance sheets, yen sensitivity and high visibility of earnings. “We’re looking to position ourselves to take advantage of those companies which will benefit from the current environment,” he says.