11/03/2008
Perspectives - March 2008
Perspectives on Japan
As the US slows, investors debate which other economies might be at risk. In this article, we examine Japan, and conclude that many of the commonly held perceptions about the country need to be re-examined.
Could Japan be an example of an economy which has de-coupled from the US? After all, economic growth has recently averaged about 1-2% a year, even a robust 4% annualised at the end of 2007. However, closer examination shows a skewed situation, with growth overly dependent on exports and investment while consumer spending was restrained by a muted labour market. The tone of the data rolled over this spring, with the all industries activity index at its lowest since 2003, and consumer sentiment downbeat reflecting low winter bonuses. On top of this, it is no surprise that export volumes to the States are currently falling by about 5% a year.
In our view, the key issue for Japan is whether regional activity holds up. Trade with the US has been overtaken by the Asian region, for example as Japanese firms outsourced production to China. Exports from Japan to other regions excluding the US are still growing about 10% pa. Indeed, we would argue that decisions by the Chinese central bank, the PBOC, are more important than decisions by the US Federal Reserve. After all, there is little the Fed can do now to have a major effect on the US economy in 2008; instead its actions may determine the pace of any upswing in 2009. In contrast, global investors generally assume steady growth from China. If the PBOC worries too much about overheating and domestic inflation, and tightens policy, the negative impact on Japan would be considerable.
If China is a wild card, currency could be another. Yen appreciation against the US dollar undoubtedly has a moderate effect on corporate profits. Here again recent changes in the composition of Japan’s trade are important. Investors should look at the real effective trade weighted exchange rate, back at its lowest levels since the 1980s. Rather than Y/$, swings in regional currencies, as well as €/Y, will be key drivers of the relative competitiveness of Japanese exporters.
Many people worry that the unwinding of the infamous carry trade could cause problems – without realising it exists in two very different forms. The first, much hyped in newspapers, involves say overseas hedge funds borrowing in yen and investing in risky US assets. Our analysis suggests that this carry trade has largely unwound in the past nine months, not a surprise as such styles generally work best in stable financial conditions. The second trade comprises Japanese domestic investors picking up higher yields in overseas bond markets. This will continue as long as the gap remains large enough to offset currency volatility. It is important to consider though why Japanese investors might change their minds and halt the trade: do they become so risk averse that domestic cash is the only safe haven, or alternatively do they prefer local opportunities? A classic example would be the dividend yield on the Topix which currently exceeds the government bond yield.
The Bank of Japan (BoJ) is clearly in a bind! It had hoped to see a classic business cycle create domestic inflation, but the end result has been a failure to generate inflation – or to be more precise, the wrong sort of inflation has appeared! Many parts of the corporate sector face a headwind, from more expensive imported commodities, while core consumer inflation is broadly flat at present. In this respect, a key trigger for investors to examine is trends in commodity prices, as a decline would provide welcome relief for many firms.
Could deflation become entrenched again? It looks much less likely because of the current strength of the banking sector. Japan is far less affected than other regions by the global credit market turmoil. After all, the major problem for domestic banks in recent years has been their inability to generate corporate and consumer loan demand, rather than being over-generous with new credit. Banks have modest exposure to US sub prime type debt compared to say their European counterparts.
In this article, we have examined a number of the complicated features of the Japanese economy: the negative impact from US trade, but the growing importance of Asian exports - which makes decisions by the Chinese central bank and moves in the yen against regional currencies so important; the inability of the authorities so far to create modest inflation and thus pricing power for companies, but the much stronger nature of the banking and corporate sectors than in the past which should prevent deflation re-appearing. While Japan remains as difficult as ever to analyse, the evolution of the economy means past rules of thumb are far less helpful.
At this juncture, using a Focus on Change approach is helpful. In terms of ‘what is in the price?’, it is noticeable that the Japanese stock market took on board many of these concerns last year, and hence has been one of the better performers so far in 2008. Such an approach can also help determine the triggers to decide whether to add to or pull back sharply from Japanese equities. At a macro level, we have outlined some in this article, for example PBOC tightening would be an adverse signal, while a decision by the BoJ to tighten monetary policy should be seen as a sign of the underlying strength of the domestic economy, and a reason to buy the stock market. At a corporate level, investors should start to research some of the opportunities in the Japanese stock market. The House View expects a complex global recession to appear in 2008, with far more pressure on consumer spending in many economies while say infrastructure spending looks far more robust. Hence, many Japanese firms look to be safe havens in an increasingly difficult global economic environment.
Andrew Milligan, Head of Global Strategy at Standard Life Investments
Standard Life Investments Limited, tel. +44 131 225 2345, a company registered in Scotland (SC 123321) Registered Office 1 George Street Edinburgh EH2 2LL.
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