Is It Time to Rethink Japan?

Sept. 19, 2003 — The Japanese stock market rebounded smartly this year after a decade of losses. But the questions facing mutual-fund investors are: Does this rebound reflect a genuine recovery in Japanese economic fundamentals, and is this resurgence sustainable?

Year to date through the end of August, Japan’s primary stock index, the Nikkei, has gained 18.7%, after dropping 21.1% in 2002, and 23.5% in 2001. Clearly, economic data coming out of Japan provides some grounds for optimism:

*Japan’s Nikkei stock average recently broke through the 11,000 barrier to a 15-month high

*Japan’s GDP rose 2.3% in the second quarter — the highest gain in the last ten years

*Japan’s Finance Ministry reported that foreign investors purchased 450-billion yen ($3.8 billion) of Japanese stocks for the week ended August 15, making it the 18th consecutive week of net buying

*Japan’s industrial sector grew by 0.5% in July, well above expectations, and represented the sixth straight month of growth

*Japanese corporate bankruptcies fell in July for the seventh straight month

“The strong performance in Japan has been driven primarily by increased confidence in the country’s economic outlook,” said Barrett Sides, co-manager of the AIM International Growth Fund/R (AIERX), which currently has 19% of its assets invested in Japan, the highest such exposure in several years.

Sheila Hartnett-Devlin, chief global equity strategist for Fiduciary Trust and subadviser for two of Franklin- Templeton’s global growth funds, concurs. “The recovery reflects an improving economic outlook and the implementation of significant structural changes, which people have waited decades for, particularly with respect to non-performing loans and poor balance sheets at banks and corporate employment practices,” she says. “These measures will allow the economy to become more productive and shed the excesses of the 1980s.”

For fund investors, this translates into gains in 2003. According to Fund Advisor, the average Japan equity portfolio has risen 21.9% year to date through the end of August. Japan’s deep decade-long economic malaise, however, has hurt performance in recent years. For the three-year period ended in August, the average Japan fund lost an average annualized 17.4%. For the five-year period though August, the average portfolio has risen 2.0%.

How strong of a yen?

A complicating factor overhanging Japan’s seemingly improving economy is the continued strength of the yen, which recently surged to a three-month high against the dollar. A strong yen would likely hurt big exporters like Toyota, and benefit stocks that focus on the domestic economy where currency movements are irrelevant. However, Sides discounts this argument. “Even though the yen just reached a three-month high, it’s really been flat for the whole year, so these are not dramatic fluctuations,” he noted.

Jason Aitken, senior analyst for the Matthews Japan Fund (MJFOX), sees a strong yen as good for Japan “because it will pressure more firms to restructure and improve its margins and returns.” But Hartnett-Devlin says a stronger yen would definitely dampen the rally. “Exports are doing well now because the rest of the world (primarily U.S. and Asia) are improving their economies,” she said. “The Bank of Japan has to keep the yen in this current trading range, or exports will be hurt.”

In macroeconomic terms, Sides believes reflation is key to Japan’s recovery. “Japan suffered four and a half years of deflation,” he noted. “The Bank of Japan and Ministry of Finance are committed to getting the country to reflate. Just a couple of points of inflation would be great to give Japanese companies some pricing power and encourage some consumer spending.”

More upside seen

Sides believes the Nikkei remains somewhat undervalued, “especially when you consider that some Japanese firms are showing their strongest operating profit growth in many years. This is what makes investing in Japan so attractive.”

The Nikkei is dominated by large-cap “old economy” companies, such as metalworking machine firm Amada Co. Ltd. and steel giant Nippon Steel, all of which have showed handsome gains this year. “There is an 80% correlation between Nikkei share prices with changes in worldwide industrial production and leading indicators,” Hartnett-Devlin noted. “The Nikkei is so cyclically-oriented, it does particularly well in a recovery.”

Hartnett-Devlin believes the Nikkei, already enjoying a nice run-up this year, can further appreciate over the next 12 to 18 months as global earnings improve. “We think the Nikkei can gain another 10% this year,” she said.

Aitken singles out financials, technology and small-caps as Japan’s best performers this year. “Financials have done well, as banks have recapitalized and credit costs are containable,” he said. “We are seeing signs of a cyclical upturn in tech — the downside selling here was overdone. Small-caps are flourishing because there is now a large number of small domestic entrepreneurial companies in Japan. Small-cap stocks are inefficiently priced in the market”

However, some skeptics point out that the Nikkei has enjoyed periods of outperformance during the last decade — surges which then petered out. The Nikkei surged 36.8% in 1999, for example. “But those prior rallies were built more on hype,” Sides countered. “Stocks would surge if the Prime Minister promised banking reforms, for example, and the market would quickly discount good news like that. Then that reform would go nowhere and the market would sink again. However, now in 2003, we are seeing some concrete and strong economic data underpinning this rally.”

Hartnett-Devlin points out that Japan’s 1999 rally occurred in a dramatically different climate. “In 1999, Japan had a very weak currency — through government intervention — which made exports very attractive,” she said. Moreover, the market was pumped up by tech and telecom stocks, which subsequently crashed. There wasn’t much structural change occurring then. Plus, people expected a fair amount of money coming out of the Postal Savings Fund and into the equity market. Thus there was no way to sustain that rally for the long term.”

Help from global economies

Still, another factor for Japan: the surging economies of its Asian neighbors, South Korea and particularly mainland China. Realizing they cannot compete with respect to cost, many Japanese manufacturers have moved their operations to China and other locales. In fact, China has emerged as both a manufacturing rival to Japan, and a major buyer for Japan’s exports.

Sides is optimistic the current Japanese rally is sustainable, “as long as the U.S. economy continues to grow, the yen remains stable (it can’t go higher than 115 relative to the dollar), and reflation is introduced into Japanese markets as the popular Prime Minister Koizumi stays on.” However, Sides concedes that Japan’s future economic health depends largely on the U.S. recovering. “Japanese markets outperform when global economies start to churn.”

Sides cautions that although Japanese corporations have made progress in reform and restructuring, it is really happening more at the micro level, not across the board. “The government is slowly deregulating the economy and dismantling barriers to efficiency,” he says. As such, individual Japanese companies now are developing a more Western-oriented focus on efficiency, return-on-equity and restructuring through the practice of formerly taboo acts as layoffs and cost-cutting.

Individual investors in the U.S., Hartnett-Devlin indicated, remain reluctant to invest in Japan. “But the institutions recognize that Japan can have powerful stock run-ups and don’t want to miss them,” she said. “Since last October when the Nikkei reached a low, institutions have been pouring money there.” She recommends that retail investors not keep more than 10% of a diversified portfolio in international stocks.