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JAPAN
by Yiannis G.
Mostrous
Editor, Growth Engines
January 19, 2006
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The reasons for that call was our assessment that Japan was coming out of its prolonged economic slump and the Koizumi government was serious about reform efforts. This was a long-term recommendation. We continue to think nothing has changed and Japan will be the biggest upside surprise of the decade. But given Japan's recent strong selloff, it's at least topical to revisit the story. Notice that Growth Engines doesn't run a portfolio (this will be a feature of our upcoming global financial advisory), and, therefore, rarely comments on the short-term gyrations of the market. After a 40-percent rally in the Nikkei last year (23 percent in dollar terms), the debate among market observers regarding the Japan market has intensified. The argument is both fundamental and technical. On the fundamental front, the idea is that the changes taking place in Japan won't be good enough to turn the ship around, and, as Prime Minister Koizumi has only nine months left in office, he doesn't have enough time to press for more reforms. Furthermore, the argument goes, Japan isn't alone in the world and, as the problems in the global economy intensify (e.g., US deficits and global extreme liquidity need to be reigned in), it will also be affected by a potential economic global rebalancing. In addition, deflationary forces are still strong in Japan and the economy will eventually be unable to pull away. Finally, the consensus is extremely bullish on Japan and, therefore, a “contrarian” move would be to bet against the newfound Japan euphoria. On the technical side, the market was clearly overbought and it was due for a correction. Plus, the argument goes, this isn't the first time the market has rallied spectacularly during its 13-year bear cycle--and it failed miserably, as the chart below illustrates. Notice the resistance level in the TOPIX at about 1,730, where the index failed before. For the time being, it's failing again, as it stopped 38 points shy of the resistance level. Therefore, the argument goes, this time might be one more failing effort. It's impossible to dispute the technical argument, as it's been clear for sometime that Japan was overbought and the market has failed to go through important resistance levels. Whether this is another unsuccessful effort no one knows. Regarding longer-term arguments, several things can be viewed differently. Growth Engines is a proponent of fiscal discipline and is concerned with the state of the global economy, something that will be examined in an upcoming issue. That said, the Japanese economy has been growing steadily, and this February will mark the fourth year of expansion--not bad for an economy coming out of one of history's worst economic recessions. An encouraging factor is domestic demand's return, as employment has been picking up and real wage growth has been accelerating. The latter is important because it allows consumers to eventually use some of the money that's been sitting in bank accounts for consumption and investment. On the corporate side, cash flows are strong, capital investment has been accelerating and domestic credit growth is starting to pick up. Exports are growing solidly, aided by China’s needs and a weaker yen. A China, or a US for that matter, slowdown could hurt exports--and both are a possibility in 2006. Net exports, however, represent only 3 percent of Japan's GDP and aren't particularly important. A slowdown in the aforementioned economies wouldn't devastate Japan's recovery. On the political front, Prime Minister Junichiro Koizumi might not have much time left, but he can still demand better performance and a faster pace from his subordinates. Furthermore, he's indicated he might consider endorsing a candidate after examining their proposals regarding economic reforms. With Koizumi’s approval rating at 60 percent, candidates--especially given the amount of popular support for change--will be more than willing to have a reform agenda to gain his support. Consequently, they would also be naïve to think they could get away without following through, although nothing is set in stone in politics. Overall, Koizumi has better control of the situation than many observers give him credit for. As I wrote in an article for MarketWatch in October--see "Secular bets: Long-term Views On Japan And Germany": “We do not mean to suggest, however, that Japan would escape the effects of a global slowdown. Rather, the Japanese seem to be determined to implement change. Of course it will take some time for the true picture to materialize, but by the time it does--and the story becomes common knowledge--the investment opportunity will be lost.” The bottom line is that, like everything else in investing, it comes down to assessment. And our assessment is that Japan's economy is in good shape. There will be some cyclical slowdowns and overexcitement at times. But as long as deflation is slowly going away and prices stabilize, Japan can become the next big equity bull market.
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