There has been one of those periodic outbreaks of bullishness on Japanese equities by several market commentators recently, notably Asian strategist Chris Wood in his Fear & Greed weekly, who posits that an inflation breakout leading to higher rates will be positive for stocks, and particularly banks. Really? The dramatic collapse of the JGB market in the last few days to yield just sub 1.7% on the benchmark 10-year, a 6 month high, certainly suggests that inflationary and rate hike expectations have suddenly spiked, and I'm a medium term bear of all government bonds. The zero rate policy has lost all economic traction; however, the BOJ has just cut its growth forecast (what a ritual that's become) and industrial output fell a scary 3.1% in March. New Governor Masaaki Shirakawa said that the downside risks to growth outweighed upward risks for the current financial year; no change there then. Japanese stocks look historically cheap compared to other developed markets, currently almost 25% off their 2007 peak, versus just 10% for the S&P. The TOPIX (1st Section) is trading at 16.5x forward earnings, 1.47x book, and 1.75% forward yield. In the short term, foreign buyers like SWFs and US mutual funds seem to have returned after a 3 month absence, but in my view the medium term outlook is bleak for a variety of structural and cultural reasons.
1. Japan faces a demographic implosion as the first developed nation to go 'ex growth' in population terms (see below). This is already leading to a secular decline in consumption patterns in markets from housing to autos, and with a GDP/debt ratio of nearly 200%, the country is in poor financial shape to cope with a soaring dependency ratio (or indeed higher interest rates). The fact that a large proportion of the under 34's have dropped out of conventional economic activity (the so called 'freeters', numbering over 6 million, two thirds of whom have never had a full time job) makes a bad situation untenable.
'In coming decades, many forces will shape our economy and our society, but in all likelihood no single factor will have as pervasive an effect as the aging of our population.' The quote is from Fed Chairman, Ben Bernanke, and I couldn't agree more.
2. Japan's terms of trade are in a secular downtrend; as an exporter of manufactured products under pricing pressure from emerging market competitors and a huge buyer of commodities from oil to vegetables, it is suffering more than any other developed country from the dramatic rise in resource costs relative to manufactured goods (hence the current inflation spike). Recent butter shortages in Tokyo are just the start of a decline in living standards as Japan is outbid by it's new competitors like China and India in world commodity markets, having failed to secure strategic supply sources in more benign times. Although the trade surplus rose sharply in 2007 for the first time in three years, the weak Yen distorted this performance (half of all Japanese exports are settled in dollars) and recent months have shown a sharp deterioration again as the Yen had strengthened.3. The Japanese financial market remains highly restricted to foreign M&A, and deregulation progress has gone into reverse in the last couple of years. The current spat between UK hedge fund TCI and local utility J-Power over dividend policy is symptomatic of a cosy corporate culture, resistant to the kind of activist shareholder restructuring which has revolutionised business in the US and Europe. This absence of any bid premium accounts for a chunk of the discount Japanese equities trade on, and this issue like many others underlines Japan's essential conservatism, likely to stay entrenched as the population ages rapidly.
4. Much of Japan's recent export growth has been generated by China's appetite for advanced engineering from machine tools to construction machinery (China is now Japan's biggest export market). I suspect China's growth rate, already down to just over 9% on IMF forecasts, will fall to mid single digits by year end, post the distorting effect of the Olympics, as tackling domestic inflation exceeding 8% takes priority over growth in Beijing (and the Chinese model is unsustainable in any case, see post); Japanese exporters will be among the biggest losers.
Forget the interminable discussions of near term interest rate policy. Japan as a market bears close scrutiny, because aside from peculiar cultural factors, the economic consequences of it passing a demographic tipping point will have implications for investors in many other developed markets, particularly Europe and indeed China, where new entrants to the workforce will halve over the next decade. Sphere: Related Content
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