Japanese outlook questionable

The Japanese economy continues to cause some concerns for institutional investors, despite signs of recovery. The recent market volatility, largely a result of the US sub-prime lending crisis, has further put pressure on a market which
has failed to see a recovery of domestic spending, although there have been plenty of predictions to
the contrary.

So, are international institutional investors turning away from the market? According to some fund managers operating in Japan, there is no real evidence of this. In fact, some argue the opposite. Whereas some maintain that there are signs that investor nerves are coming to the surface, following signs of a yen recovery and the possibility (at the time of publication) that an interest rate increase is on the cards at the next meeting of the Bank of Japan (BoJ) at the end of August.

Laura Palomino de Forbes, head of business development, EMEA for DIAM International, the asset management arm of the Mizuho Financial Group, says searches by UK and European institutions are on the increase as the Japanese market continues to show signs of improvement following last year’s underperformance. “The interest rate differential between global interest rates and the no-change in Japanese interest rates continued to widen and saw further strong capital outflow from Japanese retail investors in to foreign assets,” she says.

During July, the yen continued to weaken despite heightened uncertainty in the US credit markets and the rhetoric from Japanese officials regarding the currency’s weakness. However, it showed some indications of recovering in August, but low interest rates, compared to other global rates, continue to weigh on the currency. “We feel that yen weakness is overstretched but while the global environment remains resilient and investors continue to take risk, any strengthening of the yen may remain limited,” says Palomino de Forbes.

The weak yen has benefited exporters, but Haydn Davies, chief economist at Barclays Global Investors, is surprised that the currency has not boosted exports more and argues that Japanese equities will continue to be negatively affected. “Export orders have at least begun to reaccelerate. The puzzle is why export orders have not been stronger given the yen’s weakness. For now, the weak economic climate suggests Japanese equities will continue to underperform.

The yen carry-trade has been a fixture of markets for some time, but there are some signs of institutions buying back their short yen positions, according to State Street Global Markets’ Weekly Research Notes.

The political climate, most argue, is not making investors change their investment strategies, but at the same time many are hoping for a change at the top in order to continue the reforms started by former prime minister Junichiro Koizumi. The current prime minister, Shinzo Abe, is under pressure following an election defeat by his party in July’s Upper House elections.

Davies maintains that the more pressing concern for investors is the slowdown in the economy. “Car sales have been falling for 15 months and orders by Japanese companies for new machinery and equipment - an indicator of firms’ willingness to invest - are falling for the first time since the collapse of the technology bubble in 2001,” he says.

Davies is not convinced that the BoJ will be persuaded to hold off on increasing interest rates to 0.75%, despite the soft economic climate, as it continues its policy of returning monetary policy to a more neutral footing. “Nevertheless, Japanese interest rates will remain considerably lower than in other markets, which will continue to weigh on the yen, especially given the soft economic climate.”

He agrees that the current economic environment is good for Japanese bonds and 10-year bond yields, which currently stand at 1.8%, look good value, given that inflation is non-existent. But he argues that sentiment is still stronger in other government paper, suggesting that Japanese bonds are likely to lag.

Not all are as pessimistic, and many point to the recent flurry of merger and acquisition activity. In particular, Japanese interest in international companies, such as the $900m (€662m) bid by Fast Retailing, a Japanese retail group, for Barney’s in New York, shows that Japanese corporates are ready to flex their financial muscle. According to an analyst at UBS, the investment bank, the momentum is boosted by new rules which took effect in May, that let foreign firms use their shares to buy Japanese firms through local subsidiaries. Further deals are expected as the economy continues to improve, albeit slowly, he says.

Ed Merner, adviser to the Atlantis Japan Growth Fund, managed by Atlantis Investment Management, the independent Asian equity firm, also has a positive outlook for the market and believes the Japanese stocks will bounce back on the back of domestic investor confidence. “Over the past few years the domestic investor has been wary of the Japanese market and has chosen to invest abroad. However, as positive economic signs continue to increase, confidence should be restored, encouraging the markets to pick up. This return of domestic investment, which will be accelerated by any corrections in markets such as China and India, is the catalyst to rising Japanese stock markets.”

Merner agrees with Palomino de Forbes and says that foreign investors are returning to the Japanese stock markets because of its strengthening fundamentals, such as a relatively cheap market, strong exports, GDP growth, increasing corporate spending and more recently, stronger consumer spending.

“Economists are now discussing the outlook for spending, which is critical for the Japanese economy and stock market,” he says. “Many smaller companies undershot their earnings estimates last year, due to dull consumer spending and downward pressure on prices. However, we think this year will be different and that there is the strong possibility that consumers will slowly begin to increase spending.”

Merner believes that this year is different because of higher employment, increases in wages and bonuses. “These factors should favour the small and medium sized companies which have a relatively high exposure to the domestic economy and supports our continued focus on small and medium growth stocks, which we believe can grow earnings over the medium and longer term.”

Delphine Georges, an equity strategist at Credit Agricole Asset Management, says profitability continues to grow in Japan. “It is worth noting that companies’ financial positions are sound: they have enough flexibility in the event that growth disappoints, and they can use financial leverage from still-comfortable levels.”

Philip Whittome, head of Japan desk at Investec in London, says that although the Japanese market was weaker last year, compared to other markets the long-term investment case is sound. “Japan’s recovery is keeping up with other markets but the timing is different, hence the correlation is relatively low and this is always attractive in a portfolio, in accordance with the theory that the less correlated assets are, the more efficient the portfolio is.”

He agrees that the short-term case for Japan is more difficult because of the choppy markets. However, fund flows suggest that the pattern is consistent as money continues to pour in. In addition, in June and July ¥1.2trn worth of assets were placed in equities by foreign investors. Whittom says domestic investors, such as the large trust banks, were steady sellers but have been for some time - a scenario that has not changed in any case.

Whittom also points out that the picture looks very different depending on if you have a top-down or bottom-up view. “In the short-term, the Japanese economy looks weak. Wages fell in June and consumption was again weaker in July, which has been the case for some time. So you could say that momentum is weaker but it is certainly not in reverse or going towards recession. So the top-down view seems to indicate a slowdown.”

He argues that the bottom-up picture is reasonably good as the economy was strong last year. “One thing that needs mentioning is that most investors hoped that Japanese consumers would start spending again. This was already expected in 2006, but it is not happening.”

Whittom says the reasons behind the lack of spending were a result of nervousness among Japanese households about weakening job security, scandals such as losing the records of 50 million pensioners, making it difficult to trust the state pension system, making it necessary to rely on yourself rather than the state for the future. “It makes more financial sense to save for the future than buy handbags at this stage,” he says.

The first quarter also seem to have gone onto a good start, although only a proportion of companies have reported as the Japanese fiscal year first quarter is April-June, but those that have show net profit growth of 20% year on year.

In particular, auto companies and auto parts companies have benefited from the weaker yen, as have machinery and construction companies as a result of global growth, Whittom says.

Despite the negatives, such as a lagging economy and stock market, weak currency and political turbulence, Japanese equities remain firmly in most institutional investors portfolios as company fundamentals continue to improve and reforms, albeit limited, get underway to liberalise foreign ownership.