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Turning Japanese

Investors have been waiting for the re-emergence of Japan, when its equity market once again begins to deliver sustained returns.

Consumer spending in Japan continues to be uninspiring, with growth in real wages remaining flat to negative.

Demographics are a major issue. With one of the lowest birth rates in the world and increasing number of post-war baby boomers starting to reach retirement age, there is a significant risk of the cost of social benefits outstripping new entrants to the workforce. It is hardly surprising that savings rates are so high in this country.

Numerous factors also combine to hold back the bottom line of companies targeting export markets. Risk aversion and the unwinding of the lucrative yen carry trade has driven the yen to three-year highs against a weakening dollar. Demand from the US is faltering as its economy heads into recession.

Corporate governance (or lack thereof) remains a significant deterrent to foreign participation in the equity market. A number of companies have adopted poison-pill measures to deter would-be predators or increased their cross-holdings while maintaining one of the lowest payout ratios in the world.

All said, there is some good news for those prepared to listen. Japanese equities are very cheap by historical standards. Valuations of around 15 times earnings match those available 30 years ago. Japanese export profits will be affected by the global slowdown but their increasing exposure to emerging economies should lessen the downside and prove profitable in the future. Corporate Japan appears to recognise the challenges it needs to face up to, with an increased focus on expanding product ranges and diversifying geographically.

Domestic factors may also suggest a rosier future. If ongoing union negotiations are effective in achieving increased wages, they could assist domestic demand. With the stronger yen hampering export growth, the upcoming G8 summit in July may mark a point where the authorities commit to intervention in the foreign exchange markets. Furthermore, the need for government to commit to a meaningful reform agenda is now widely recognised.

In recent weeks, stocks have advanced despite poor macroeconomic data, as rising inflation expectations prompt optimism over consumer spending and that some of the estimated 730trn yen in household savings will be put to work in domestic equities.

Financial counters have enjoyed a strong run, led by blue-chip banks, after quarterly earnings results revealed little in the way of low-grade mortgage exposure or exotic derivative contracts that have plagued many Western counterparts. Heavy short-covering and portfolio repositioning from investors underweight in the sector has also aided performance.

From a broader Asia Pacific perspective, we are cautious about Japan’s short-term prospects and believe that a major spark is needed to reignite the market and the economy. We are holding a 45 per cent weight to Japan, which is significantly underweight compared with our benchmark, and we are adding to it very selectively. We continue to favour China and recently increasing exposure on expectations of more positive government rhetoric and market-friendly policies has worked well.

Nervousness over the credit crunch is dissipating following soothing comments from US Treasury Secretary Henry Paulson and the heads of several major banks and while the prospect of further mortgage-related write-downs cannot be ruled out, there is a growing sense that the Fed has been proactive enough to avert an immediate systemic crisis.

With domestic Asian indices increasingly taking their lead from global cues, particularly events in the US, increasing conviction that a G7 recession will be shorter than expected gave the impetus for a rally across the region.

Jonathan Schiessl manages the Ashburton Asia Pacific fund


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