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M O N E Y W A T C H
Weekly Financial Commentary from Tokyo
Issue No. 35
Wednesday, July 9, 2003
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Viewpoint: If Government Can Avoid Crisis, Grass-Roots Restructuring
Holds the Key
The Bottom Line:
o Money Watch's calls ago that the bond market correction was
just a hiccup (MW 33) and that the stock market rally was
short-term (MW 32) were not looking too smart last week, as
sell-offs in JGBs and other global bond markets had the
world's financial ministers gulping while trading volumes on
the TSE were soaring.
o This notwithstanding, both the US and Japanese governments
desperately need to keep bond markets from getting too far
ahead of whatever good economic news is in the pipeline if
they want to keep their equity rallies intact. If this is the
long-awaited crash of Japan's bond-market bubble, investors
need to be more concerned about a possible fiscal crisis
and/or a financial crisis than whether or not they are lagging
behind the MSCI Japan benchmark.
o While the Nikkei rally is the best since early 2002, there
have been six bear market rallies in the Heisei bear market,
two where stocks rallied more than 50 percent. Thus domestic
investors can be forgiven for being skeptical that the current
rally is anything more than a respite from an ongoing secular
o There are, however, two indicators that bear close watching.
One is the continued expansion in trading volumes. The trading
volumes in this rally exceed those in any rally so far in the
Heisei bear market. Moreover, trading volumes have gradually
been recovering from a secular trough in 1992. The other
indicator is the steadily improving trend in free operating
cash flows, which have been moving in opposite direction to
the Topix and have been consistently positive since the
April-June quarter of 1997. Grass-roots corporate
restructuring and revitalization will eventually be the
catalyst for a secular trough in Japanese equities if the
Japanese government can avoid a major fiscal crisis, a
financial crisis, a depression and a major crash in the bond
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If Government Can Avoid Crisis, Grass-Roots Restructuring
Holds the Key
Money Watch's call that the bond market correction was just a hiccup
was not looking too smart last week, as investor sentiment regarding
the world's bond markets shifted suddenly and dramatically. Investors
shunned government bond auctions in Germany and Britain, with some
analysts commenting (as reported in the Financial Times on July 3)
that the German bond auction was the worst seen in 12 years.
Weak demand at Thursday's auction of Japanese government bonds (JGBs)
in Japan also rattled investors and produced the biggest one-day jump
in yields in four years. Bloomberg quoted one Japanese fund manager
who described the auction as close to a failure, even though the issue
attracted bids 1.68 times the amount sold when the Finance Ministry
raised the coupon from 0.5 percent to 0.9 percent. JGB yields have
surged from lows of 0.43 percent in June to 1.400 percent on Friday,
before selling off to 1.045 percent. What had the world's financial
ministers gulping was the negative market reaction to the Federal
Reserve's quarter point reduction in the Fed funds rate; many had
expected a half-point cut. Investors were also surprised that the Fed
appeared to show diminishing concern for deflationary risks and was
fairly upbeat on the economy, despite all the warnings by the "street"
about the impending risk of deflation. The Fed also made comments
about the need to take out insurance against deflation.
Investors want to hear more assurances from the Fed that rates will
stay low for a long time, even if the US economy begins to recover.In
Japan, the Bank of Japan got the blame for the spurt in JGB yields.
The release of the minutes of the BOJ's policy board meeting on April
30 had BOJ watchers pointing to comments by some board members that
JGBs were slightly over valued at 0.61 percent. The minutes of the
BOJ's May 19-20 monetary policy board meeting (released on June 30)
indicated that more board members were concerned about the recent
sharp declines in JGB yields and of a spike in rates. More disturbing
to the bond bulls was the implication that the BOJ may not be willing
to buy bonds at "any" price.
This notwithstanding, both the US government and Japan desperately
need to keep bond markets from getting too far in front of whatever
good economic news is in the pipeline. For the US, an unruly bond
market could upset the best laid plans for economic recovery by the
Bush administration and the Fed. Unfortunately, the relative stability
seen so far in the US economy has come at the cost of economic
imbalances and wobbly financial markets. In addition, sharp
bond-market corrections can be messy and financially painful, as was
seen in 1998 when the Fed felt compelled to bail out Long-Term
Capital. The Fed's proactive monetary policy has slowed the unwinding
of the US economy's imbalances, while at the same time supporting a
refinancing boom that has kept the US housing market vibrant.
For the Finance Ministry, keeping a lid on rates means minimizing
growing funding needs. The ministry had conservatively projected
10-year JGBs at 2 percent in this year's fiscal budget, but
large-scale JGB issues are set to continue. Japan already has the
world's largest bond market, with $4.7 trillion in marketable
securities; in comparison, the US has $3.3 trillion. The spike in JGBs
is already leading to higher long-term prime rates, which are set to
increase from this week. Prime lending rates are set by Japan's major
banks on the basis of yields on their five-year interest-bearing
debentures. The ministry is also looking at raising rates on the
interest it charges on loans to special government-sponsored
corporations, and finally, new rates on housing loans will also
reflect the higher benchmark interest rates. Salaried workers are
already spending sleepless nights wondering how they will be able to
maintain their housing loans with shrinking bonuses.
True, industrial output jumped 2.5 percent in May, and investors are
speculating about improving corporate earnings. But, even as the BOJ
was announcing the results of its latest quarterly business survey,
known as the tankan, which surprised investors with the biggest
improvement in business sentiment seen in a long time, the
Ministry of Economy, Trade and Industry (METI) was downgrading its
assessment of the local economies, from "largely flat" to "largely
flat with some evidence of weakening." Dai-ichi Life estimates that a
100-basis-point rise in interest rates would shave 0.1 percent off GDP
growth in the first year and 0.5 percent in the second year. Moreover,
the big picture for Japan is that the financial system remains very
fragile, with major banks being dangerously short of capital and
"smoke and mirrors" deferred tax assets amounting to some 70 percent
of the top 11 banks' capital.
In addition, former Finance minister Eisuke "Mister Yen" Sakakibara
and others estimate that it would take trillions of yen in public
funds for a full-scale cleanup of Japan's banking system, even with
the Industrial Revitalization Corporation.
So far, the stock rally to over 9,500 on the Nikkei has produced
massive valuation gains on equities. Thus, for the time being, the
banks and the major life insurers have been net beneficiaries of the
combined stock rally and bond market rout, but the phones have already
been ringing at the LDP, the Finance Ministry and the BOJ with concern
that the bond market rout could get out of hand. Finance minister
Masajuro Shiokawa on Friday said that "if yields rise any further, we
will need to consider countermeasures." Financial Services Agency
(FSA) chief Heizo Takenaka chimed in that "we must avoid a situation
where funding the government deficit pushes up interest rates." Bond
market volatility has prodded the FSA to increase its monitoring of
the banks and their unrealized profit-and-loss situations for bonds.
The sharp run-up in yields also has politicians and the government
again looking to the BOJ, and private sector economists speculating
about how much they could ostensibly increase their purchases of JGBs.
Consequently, while the bond market hiccup Money Watch initially
foresaw is more like a gulp (as the Japanese government ponders the
implications of a crash in bond prices), our working assumption
remains that the Finance Ministry, the Koizumi administration and the
Liberal Democratic Party will do everything in their power to avoid a
more serious bond-market crash. In addition, Japan's economy is
nowhere near a classic "demand-pull" recovery that ostensibly would
drag interest rates upward with it. Indeed, a more probable scenario
at this juncture is that the government's pressing need to continue
issuing large amounts of bonds would lead to a crash in the JGB
While the rally in the Nikkei is the best seen since early 2002, it
pales when compared to how far the index has imploded since its
secular peak in 1989. Indeed, there have been six rallies in excess of
20 percent during the Heisei bear market, with two surging over 50
percent trough-to-peak before eventually resuming the downtrend. Even
the IT boom-driven rally between 1999-2000, as large as it was, proved
to be a brief interlude in the secular bear market. As the current
rally represents the seventh bear market rally, investors can be
forgiven for being skeptical that the rally is anything but a brief
respite from a secular bear market.
Like global equity and bond markets prior to the last few weeks, the
Nikkei index and JGBs had been sending a paradoxical message. The
stock market bounce ostensibly was signaling growing investor
confidence in better economic growth and a recovery in corporate
profits. The bond market, on the other hand, was assuming that
deflation would continue as far as the mind could see. But business
and consumer sentiment in Japan has been improving since the end of
the formal war in Iraq, the passing of the SARs epidemic, the bailout
of Resona Bank, the inauguration of the Industrial Revival Corporation
of Japan and the upside surprise in the latest tankan.
Perhaps an even greater factor in improving stock market sentiment was
increasingly obvious signs that the FSA was backing away from the
"hard landing" scenario that Takenaka outlined when he first assumed
his post as minister there. When Takenaka assumed his new post on
September 30, 2002, the Nikkei index was peaking around 9,885, and as
concern about the hard landing approach to the banks, the Iraq War,
and SARs were peaking, the Nikkei hit a new post-bubble low of 7,608
on April 28. After a forcing of the issue regarding deferred tax
assets (DTAs) led to a government bailout of Resona Bank, the FSA has
indefinitely postponed its proposal for tougher countermeasures to
strengthen the capital positions of the other major banks.
While the domestic media has attributed the current rally to foreign
buying, brokers trading their own accounts and individual, "semi-pro"
investors have been just as, if not more, responsible for the rally.
Online brokers like Matsui Securities are doing record trading
volumes, while the money made in the past couple of weeks from
proprietary trading by some of the smaller "full-service" brokers has
equaled that of the entire month of March. Domestic brokers and
"semi-pro" individual investors have in the main preferred the junk or
"penny" stocks. Trading in these low-quality stocks has soared.
Foreign investors, on the other hand, have preferred the higher-priced
Thus, the rally resembles an excess-liquidity rally more than it does
a rally driven by a substantial upgrade in fundamentals.
Secular Indicators That Bear Watching
However, two long-term indicators are beginning to suggest that, from
the bottom up at least, the end of the Heisei bear market may be in
1. Continued expansion in trading volumes. The continued string
of days with more than 1 billion shares traded during this
rally is unprecedented during post-bubble market history.
Since 1990, this amount of trading volume has never lasted
more than three days. Moreover, if you visit the Tokyo Stock
Exchange's Web site (http://www.tse.or.jp) and graph the
historical Topix with trading volumes, you will discover that
the trend in trading volumes actually bottomed in 1992 and has
been rising ever since to current levels that approach the
sort of volumes seen during the bubble years.
2. An even more interesting phenomenon is the fact that the
direction of free operating cash flow for companies with
billions of yen in paid-in capital has actually been steadily
improving after bottoming in the April-June quarter in 1991,
while the Topix and the Nikkei have continued to head south.
Operating free cash flow (as calculated by the product of Ebita plus
the difference in the change in account receivables and account
payables, minus the change in inventories) for the large companies in
the Finance Ministry's comprehensive survey has been consistently
positive since the April-June quarter of 1997. It is, however,
slightly overstated because investments in software are not included
in capital expenditures. But judging from the combined fixed and
software capital investment numbers from the BOJ's tankan, the capital
investment numbers in the Finance Ministry survey are understated only
by 6-7 percent.
Conversely, the Topix has been moving in the opposite direction during
this period, proving the old adage that just because stocks are
"cheap" they cannot get cheaper. The decline in stock prices is thus
not due to deteriorating cash flows, but rather to:
1. A correction of the gross mis-pricing of stock prices during
the bubble, where irrational exuberance resulted in
unrealistically high assumed growth rates becoming embedded in
stock prices. Merely re-pricing stocks to more realistic
assumed growth rates given Japan's current potential growth
rate and international competitiveness would have been enough
to cause a substantial correction in stock prices, even
without the bursting of the bubble.
2. A structural unwinding of cross-holdings, and cash being
withdrawn from financial markets to service ever-growing debt
that arose from the bursting of the bubble. In other words,
there was less money available to support stock prices.
Consequently, if the Japanese government can avoid a major financial
crisis, a depression and a major crash in the bond market (and Money
Watch is not absolutely confident that they can), grass-roots
corporate restructuring and revitalization could be the catalyst that
eventually halts the Heisei bear market and produces a secular trough.
As the US market was beginning to emerge from its 20-year malaise in
1983, there was widespread disbelief and puzzlement that stocks were
as resilient as they were despite the plethora of perceived macro
problems at the time. Thus investors will very likely be able to
confirm the secular bottom in the Japanese market with 20:20
hindsight. For the time being, however, there remains the not
inconsequential probability that this secular low will be established
only after there is a purging of the structural impediments preventing
economic recovery in Japan, with the overwhelming experience of the
purging being the catharsis for the trough.
-- Darrel Whitten
THE ABW MARKET LETTER
"What You Should Read After Irrational Exuberance"
A weekly strategic analysis of Japan's economy and
financial markets with views you use.
Subscribers: 560 as of July 9, 2003
Written by Darrel Whitten email@example.com
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