Is The Worst Finally Over For Japan?

On the eve of a crucial general election in Japan, many observers are wondering if an apparent economic recovery can sustain itself.

On the eve of a crucial general election in Japan, many observers are wondering if an apparent economic recovery can sustain itself.

In short, Japan's stock markets, in a malaise for over a decade, have been rebounding. But even the most optimistic investor questions whether this buoyancy will last, given that past recoveries all flickered out. Are things really different this time around? And should U.S. mutual fund investors put money back into Japan?

For the year ended August 26, the average Japan-focused equity mutual fund rose 12.1%, versus a gain of 10.8% for the S&P 500-stock index. Over the three-year period, the average Japan fund registered an average annualized return of 11.9%, versus 10.5% for the index. For the five-year period, Japan funds dropped 6.4%, compared with a 2.8% decline for the Index.

The quantitative evidence seems to support that an economic recovery is well underway in Japan. In mid August, the Nikkei-225 stock index and the Topix index both reached roughly four-year highs. Moreover, Japanese GDP grew for a third consecutive quarter, and is expected to rise 2.5% for fiscal 2006. Employment is also better. In June, the country's jobless rate dropped to 4.2%, a seven-year low; and consumer confidence, though still sluggish, may improve as more people have money to spend.

Mark Headley, lead manager of the $185-million Matthews Japan Fund (MJFOX), believes Japan's recovery has legs. He says that the country's Central Bank is intensely focused on ending deflation, which has been "extremely brutal on consumer spending habits, on corporate balance sheets, and brought their entire banking system to the brink of bankruptcy." The Bank's Governor, Toshihiko Fukui, he says, "would rather risk some inflation than risk continuing deflation. This is most evident in the huge Tokyo property market, where we're seeing a broad-based turnaround and stabilizing prices. Hopefully, that spreads to the wider economy."

The pace of corporate restructuring in Japan has also contributed to a brightening economic picture. Patricia Higase, co-manager of the Matthews fund, says that "corporations are streamlining, focusing on improving their bottom lines, rather than just the top-line. With improved profitability and stronger balance sheets, companies have the free cash flow to pay down debt and increase operational efficiency."

While annual GDP growth of just over 2% might seem modest, Headley points out that "as a very rich and mature economy, Japan does not need high GDP numbers to carry a sustained bull market, unlike Korea, China and India. Japan is basically 'Switzerland multiplied by ten'."

Matt Hudson, manager of the $326-million American Century Global Growth/Inv (TWGGX), believes the real catalyst behind Japan's resurgence is based on optimism that Prime Minister Junichiro Koizumi will win [the] general election, thereby enabling the quicker passage of his reforms. "Although economic fundamentals are clearly improving across the board, this rally has been driven by, and will largely depend upon, how successful Koizumi is," Hudson says.

Koizumi called a snap election after the Japanese parliament rejected his proposal to privatize the country's state-run postal service. With about 350 trillion yen ($3.3 trillion) of assets in consumer savings and insurance deposits, the 'Japan Post' essentially functions as the world's largest saving bank. Unleashing this vast amount of money, which would then be reinvested into the economy, could spurt further growth. But Koizumi may face an uphill battle. Many members of his own ruling Liberal Democratic Party oppose the proposed sell-off. "If the election goes Koizumi's way, he can get the dissenters thrown out of Parliament, and, it is hoped, push his reforms through," Hudson says. "The election is the galvanizing event in this rally."

One factor that has contributed to the stagnation of Japan's economy, cross-shareholding, appears to be winding down, Headley says. Cross-shareholding is a long-standing Japanese corporate practice whereby the management of one company buys up significant shares of another company, often in the same industry. Big commercial banks, in particular, have participated in these cross-equity deals. This tactic is seen as a 'defensive' measure by executives to prevent the threat of hostile takeovers, but it really serves to diminish the influence of public stockholders.

Meanwhile, foreign buying of Japanese assets is accelerating, as international investors seek to participate in Japan's growth and purchase stocks that remain cheap relative to U.S. and European equities. Headley notes that in June, Japan became a net recipient of foreign direct investment for the first time ever. "Domestic pension money and global institutional money are going into Japanese stock markets, especially Tokyo property markets," Headley added.

Perhaps the greatest obstacle to a sustained recovery is the high price of crude oil, which just touched an all-time peak of more than $70 per barrel before pulling back. Though Japan imports nearly 100% of its oil, high crude and commodity prices pose risks to all global economies, not just Japan. On the plus side, however, Japanese companies are extremely energy efficient by necessity. According to data from Goldman Sachs, Higase notes, Japanese consumption of oil as a percentage of GDP "has declined substantially because companies have triggered a lot of energy-saving initiatives. This figure has plunged from 120% in 1970 to 52% in 2004."

A key to the strength of Japan's economy is its large and diverse financial sector. Japanese banks have restructured, cut their bad loans, and have started to boost lending. Banks are particularly positioned to do well, since they are leveraged to an improving economy, Headley notes. As a stock-picker, he likes Japanese banks, brokerages and insurance companies. "Financials are a good way for investors to participate in a restructured and reflated Japan," he says. "There is a lot of potential for growth here. Japanese consumers are one of the most underserved communities of wealthy people on the planet."

Higase is also bullish on Japan's technology and retail sectors, particularly the online e-commerce business, a play on increasing consumer confidence. As of July 31, Matthews Japan had 33.5% of its assets invested in consumer discretionary stocks, and 23.4% in financials.

TOP PERFORMING JAPAN FUNDS (ONE-YEAR)*

FUND

RETURN (%)

DFA Invest Group Japanese Small Company Port (DFJSX)

+21.7

ProFunds:Ultra Japan/Inv (UJPIX)

+20.8

JPMorgan Japan/A (CVJAX)

+17.1

T Rowe Price Japan Fund (PRJPX)

+16.6

PIMCO:JapaneseStock+TotalReturnStrategy/Ist (PJSIX)

+16.5

Average Japan Fund

+12.1

S&P 500 Index +10.8

TOP PERFORMING JAPAN FUNDS (THREE-YEAR)*

FUND

RETURN (Annualized %)

DFA Invest Group Japanese Small Company Port (DFJSX)

+26.5

Fidelity Japan Smaller Companies (FJSCX)

+21.2

Matthews Japan Fund (MJFOX)

+18.2

JPMorgan Japan/A (CVJAX)

+17.2

The Japan Fund/S (SJPNX)

+16.9

Average Japan Fund

+11.9

S&P 500 Index

+10.5

TOP PERFORMING JAPAN FUNDS (FIVE-YEAR)*

FUND

RETURN (Annualized %)

DFA Invest Group Japanese Small Company Port (DFJSX)

+9.0

Fidelity Japan Smaller Companies (FJSCX)

+3.4

JPMorgan Japan/A (CVJAX)

-1.8

Matthews Japan Fund (MJFOX)

-3.0

The Japan Fund/S (SJPNX)

-3.1

Average Japan Fund

-6.4

S&P 500 Index

-2.8

*Data through Aug. 26, 2005

Source: Standard & Poor's. Total returns are in U.S. dollars and include reinvested dividends.

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