J@pan Inc Magazine Presents:
M O N E Y W A T C H
Commentary on the week's music technology news
Issue No. 39
Monday, August 11, 2003
++ Viewpoint: Election Scenarios and the Banks
The Bottom Line:
Top-Down: Election Scenarios and the Banks
o The merger of the Democratic Party of Japan and the Liberal
Party has led to speculation that general elections in
November will be basically a two-party affair, and the new
combination has apparently closed the gap between the
potential opposition and the Liberal Democratic Party to a
level not seen in quite a while.
o While the old guard in the LDP would dearly love to depose
Heizo Takenaka from his powerful posts, the US government is
voicing support, and the sad fact of the matter is that no
young lion within the ranks of the old guard of the LDP
really wants Takenaka's hot seat. Takenaka and the Financial
Services Agency are currently keeping their heads down due to
the storm of resistance stirred up by their Financial Revival
Program, announced late last year.
o But if Prime Minister Junichiro Koizumi is re-elected as
president of the LDP and fends off the new opposition in the
November general elections as well as the upper house
elections next year, he will have a rejuvenated "mandate" for
reform, and Takenaka will have a freer hand to push harder for
bank reform and keep the major banks on their toes until they
actually turn the big corner in the nonperforming-loan
Bottom-Up: Are Cyclicals Really the Place to Be?
o Globally, investors have a renewed interest in cyclical
stocks. This renewed interest in cyclicals has directly
benefited Japan, which has historically (at least during the
Heisei Malaise) shown strong cyclical characteristics. But the
better strategy, say those who have studied the performance of
US cyclicals at length, is to buy the cyclicals in the last
year of falling rates, just before rates begin to rise again,
as this is when cyclicals tend to outperform growth stocks.
o If that is the case, then investors have lost their window of
opportunity to buy cyclicals, given the sharp run-up in
interest rates that is ostensibly driven by overly optimistic
expectations of an economic recovery and the post-Iraq war
dynamic of sharply expanding US government deficit-funding
o Like the bank subsector index versus the Topix, the Nikkei 225
and the Topix indexes bottomed out after the Nasdaq in this
rebound, but topped out first. Rather than market leadership,
this suggests the move in Japan was predicated on the rally in
o Buying the laggards (Japan stocks) may work on a relative
basis for a time, but if the US market (the leaders) are in
trouble, it's only a matter of time before the leaders drag
down the rest of the pack.
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++ Viewpoint: Election Scenarios and the Banks
Recent political party changes remind long-time observers that in
Japan, the more things change the more they are the same. This
summer is the 10th anniversary of what many foreign observers
thought -- at the time -- was the beginning of Japanese political
reform. An article in the August 2, 1993 edition of Newsweek stated
that "it does seem clear that the LDP's long monopoly on power is
history." The domestic media termed it "the beginning of a new age" in
Not everyone in Japan was fooled. At the time (in the same
Newsweek article) Takashi Inoguchi, a political science professor at
the University of Tokyo, threw cold water on all this enthusiasm
when he dryly cautioned, "Don't underestimate the power of
inertia in Japanese society." That cautionary statement is as
true as ever today.
Ichiro Ozawa of the Liberal Party has teamed up with Naoto Kan of
the Democratic Party to challenge one of the most popular
Japanese prime ministers in LDP history. According to the
Japanese media, the Democratic Party is closing the gap with the LDP
as the party of choice in the upcoming lower house election in the
fall, as the latest nationwide opinion poll conducted by Nihon Keizai
According to the Nikkei poll, 24 percent of the respondents said
they would vote for candidates from the merged Democrat-Liberal Party
entity, compared with 32 percent who support the LDP. The figure is
up by 3 percentage points from the sum of the support levels for
the two parties in the previous survey conducted in June,
indicating that the merger of the parties may be having a
positive effect on the political fortunes of Japan's long-
About 81 percent of Democratic Party supporters and 78 percent of
Liberal Party voters say they will choose candidates from the merged
entity. Among independents, the merged party was backed by 17 percent,
the highest level for any party. Respondents in their 50s chose the
Democratic Party over the LDP by 31 percent to 28 percent.
Salaried businessmen expressed support for the Democratic Party and
the LDP in nearly the same numbers -- 27 and 28 percent, respectively.
But while 31 percent of the men polled support the Democratic Party,
just 18 percent of women plan to back the party. Only 19 percent of
homemakers say they will vote for the Democratic Party, highlighting
the party's known weakness among women. The survey received valid
responses from 2,010 voter households.
The last time the gap between the LDP and the Democratic Party was 10
points or less was in February 2001, in the final days of the
government led by prime minister Yoshiro Mori. Given that the
percentage of respondents who intend to vote for the LDP is the lowest
since Junichiro Koizumi became prime minister, the next lower house
election is shaping up to be a two-party race between the LDP and
The current election timeline is that the LDP will elect (or re-
elect) its next president in September, followed by a dissolution
of the Diet in October and a general election in November.
Koizumi, of course, wants to use the LDP presidential elections and
subsequent general election as a re-affirmation of his reform agenda.
He offers the prospect of cabinet posts not only to political
outsiders, but to "opposition forces" in the LDP and even members of
opposition parties, if they agree to cooperate with his policies.
However, on a purely factional basis, Koizumi is backed only by
factions led by Mori, Taku Yamasaki and Sadatoshi Ozato,
who combined have only 100 members. Thus he needs widespread
support from the LDP rank and file to be re-elected as LDP
president. The last time he carried the regional party members.
This time may not be so easy, some suggest.
Ryutaro Hashimoto and his faction are arch rivals to Koizumi, and
want to select an alternate candidate. Hiromu Nonaka, a still-
powerful figure within the LDP, has let it be clear that he and
others will oppose Koizumi and unite behind a rival candidate as well
as a slate of prospective cabinet members in the upcoming party
The opposition of Nonaka and others in the LDP to Koizumi is
being motivated by the administration's economic policies, which
they consider abysmal, and by Koizumi's expression of
satisfaction that the LDP has been "half destroyed."
In deference to upcoming elections, the Financial Services Agency
(FSA) is trying to keep its collective head down politically. If
Resona's receipt of taxpayers' funds for survival triggers more bank
trouble involving the "Big Four," including Mizuho Financial Group,
Koizumi will face an uphill battle to gain re-election as president of
his party. Both LDP opposition leader Hashimoto as well as opposition
party leaders are taking pot-shots at the Koizumi administration,
demanding that the prime minister change his reform-oriented economic
policies in the wake of the Resona bailout.
The Hashimoto faction is claiming that the economic reform policies of
Koizumi failed when the government decided to inject funds into Resona
on May 17. They in particular would like to see Takenaka, currently
state minister of financial, economic and fiscal policy, sacked or at
least have his currently powerful job significantly downsized.
This gives rise to some speculation about the Japanese government's
policy toward financial reform given different election scenarios. The
positions have been staked out through pronouncements of key persons
from each group.
1.The "kinyu zoku," or "finance tribe," consist of core members of the
Hashimoto faction and the LDP. When LDP executives met to exchange
views, they discussed the FSA's decision to issue management
improvement orders to 15 banks. Mitsuo Horiuchi, chairman of the
party's General Council, criticized the FSA for claiming the banks'
earnings performance has been bad.
In fact, the FSA's policy measures are partly responsible for their
results. Seiichiro Murakami, the party's deputy secretary-general,
insisted that "the approach is dangerous, as it might push some banks
to the brink of collapse."
Shizuka Kamei has criticized the Koizumi administration for its
schizophrenic policy of pushing the banks to accelerate bad loan
liquidations, while at the same time threatening to fire bank
management if they do not improve their earnings.
2.In fact, the Koizumi administration is the center of the issue
vis-・vis the other two groups. Both Ozawa and Kan insist that
Takenaka has taken the wrong approach, insisting that the 2 trillion
yen in funds injected into Resona were a de facto admission of a
failure of policies implemented heretofore to stabilize Japan's
The three possible election scenarios are as follows, ordered
according to Money Watch's perception of their probability:
a) Koizumi is re-elected as president of the LDP and prime
minister, this time with a stronger reform mandate. The LDP old guard
(even within the factions that support Koizumi) will undoubtedly
continue pushing Koizumi hard to dump Takenaka, but in reality,
Koizumi's interests lie more in privatization, and he has literally
completely delegated financial issues to Takenaka. Given a
reconfirmation of the Koizumi administration's mandate, Takenaka would
feel freer to push harder on bank reform,for a clearer definition of
bank deferred tax assets and to be more proactive in injecting capital
into major banks that need it. The US is evidently rooting for the
Koizumi administration and his reformist agenda,as Takenaka's recent
visit to the US drew unusual coverage of statements of support from
key US officials.
b) The Democrat-Liberal alliance pulls off a two-staged upset. It
is very unlikely that the new alliance could win enough seats in the
November election to gain power. But if the LDP were to lose a
significant amount of seats to the new alliance in the November
elections, the pressure on Koizumi would intensify.
Koizumi's cabinet would be weakened, and if pushed hard enough, he
would first move to downsize Takenaka's position. However, it is
likely that Takenaka would still remain as financial services
minister, as Mr. Koizumi's interests lie in privatization, and there
are few in Kabutocho who covet that post.
Upper house elections next year would be even more important,
given further losses by the LDP, which already no longer holds a
majority. Should the alliance eventually gain power within the
next two elections, one might even see a flashback to the 1998
Diet, where a group of young Democrat Party policymakers pressed for a
tough approach toward banks.
c) The old guard returns. If anti-Koizumi forces win the LDP
presidential race, the new LDP president will likely postpone the
general election until next spring or later and adopt more of a
"sunshine policy" toward financial institutions. This would
allow the banks to breathe easier in the short term, but it could
create a voter backlash in the upper house elections next year.
The reason anti-Koizumi factions have yet to agree on a unified
candidate for the next LDP president is that party members feel
that if an opponent of Koizumi became the next prime minister, the
party would face an uphill battle in the elections, especially against
a stronger and more unified opposition. At the end of the day,
however, the power struggles within the LDP will be a tempest in a
teapot if the Democrat-Liberal alliance produces a real alternative to
the LDP in the general elections. Problem is, Money Watch believes
that is a very big "if." As Inoguchi of the University of Tokyo has
said, "Don't underestimate the power of inertia in Japanese society."
The Rally in Equity Markets is Breaking Down
As Money Watch has been saying for some time, its time for a reality
check. The technicals of the US equity market are lousy, at least
over the short term. The rally in US stocks is running out of
steam, with the Dow Jones industrial average, Nasdaq and Russell 2000
all showing "dead crosses" between their 20-day and 50-day moving
averages, indicating at least an interim correction. Chartists (like
Money Watch's old colleague Ralph Acampora of Prudential) say that
market internals remain poor, part and parcel, and they see further
correction ahead, even though the medium-term prognosis is still
upbeat. At the end of the day, the equity market would feel a lot
more comfortable if bond prices were more stable.
Bond Rout; Time for an Interim Reversal?
The rout in the US bond market has reached the front pages, meaning
that the back-up in yields could well have peaked for the time being
because the run-up in interest rates has gotten well ahead of the
budding economic recovery.
The US treasury market was the largest in the world until 1999,
when it was overtaken by the mortgage securities market. With
$923 billion in assets, the Federal National Mortgage Association
(Fanny Mae) is the second-largest financial company in the US, behind
CitiGroup. Agency (Fanny Mae and the Government National Mortgage
Association, or Ginny Mae) securities are not guaranteed by the US
government, but most investors believe that the Fed would bail them
out if they got into trouble.
Fanny Mae apparently faces bigger losses from interest-rate swings
than it has publicly disclosed, claim critics. According to reports,
Fanny Mae's own computer models show that its giant portfolio would
have lost almost $8 billion in value if interest rates rose overnight
by 1.5 percentage points earlier this year. At the time, the market
value of all assets minus the company's debts was $15 billion. So
Fanny Mae would have lost half its market value from a rapid 1.5
percentage point rise in rates.
Fanny Mae is just one example of what could happen if US rates got out
of hand. The bullish case for US equities was predicated on the
loads of monetary and fiscal stimulus being thrown at the US
economy. But in reality, the only real point of traction so far
has been the massive amounts of mortgage refinancing through
which US consumers raised hundreds of billions of dollars. This
was the primary reason consumer spending held up so well during
the recession and emerging recovery. This stimulus is now
disappearing from the economy as mortgage refinancing appears on
the verge of collapsing under the sharp run-up in interest rates.
Moreover, the aftermath of the Iraq invasion is that, after
having dangled its intention to employ the non-traditional policy
of buying long-term government bonds to prevent deflation and
promising "to do whatever necessary" to prevent deflation in the
face of bond market bulls,the Fed then backed away and began
talking about an economic recovery.
Meanwhile, the administration raised its budget deficit estimates
to record amounts, and it suddenly became obvious that these
deficits could do nothing but continue to increase as far as the
eye can see. The amount of money to be financed by the Treasury
Department has already increased in geometric proportions and
looks like it will only get worse. The Bond Market Association's
economic advisory committee forecasts a US federal government deficit
of $400 billion, a 153 percent increase over fiscal 2002's deficit of
Thus, in Money Watch's view, the US market is now trying to
transition,from an "excess liquidity" driven market to an earnings
(fundamentals) driven market. The transition inevitably involves an
interim correction. If the US economy really is turning the corner,
earnings will eventually come through to support the market. If,
however, interest rates lead the fundamentals by too far a margin, the
US market could get stuck in a medium-term trading range.
Are Cyclicals Really the Place to Be?
Globally, investors have a renewed interest in cyclical stocks as
expectations for a recovery in the US economy were on the rise.
Historically, falling interest rates have been a factor in the
cyclical's best years, but the better strategy, say those who
have studied the performance of US cyclicals at length, is to buy
the cyclicals in the last year of falling rates, just before
rates begin to rise again, as this is when cyclicals tend to
outperform growth stocks. If that is the case, then investors
have lost their window of opportunity to buy cyclicals, given the
sharp run-up in interest rates that is ostensibly driven by overly
optimistic expectations of an economic recovery and the post-Iraq
war dynamic of sharply expanding US government deficit-funding
The Japan Connection
This renewed interest in cyclicals has directly benefited
Japan, which has historically (at least during the Heisei Malaise)
shown strong cyclical characteristics. This is because most of
Japan's larger listed companies have long since ceased to be
secular growth stories. Indeed, even Japan's high-tech majors in the
1990s (with the brief exception of the Internet boom in 1999-2000)
have become cyclical stocks that are highly leveraged to overseas
economies, particularly the US economy.
The Cyclicals Already Ran
With the Nikkei 225 having twice tried to breach 10,000 and
failed, market pundits are suggesting that foreign investors
trade down to "domestic-oriented" cyclical stocks. But the obvious
domestic "cyclicals" (such as the steel and technology stocks) have
already had a good run, while the April-June quarter earnings show
that the transition to upward earnings revisions for the large,
integrated Japanese technology stocks will be mixed at best.
Thus, like the US, the plain vanilla envelope cyclicals in Japan
have already had their "15 minutes of fame," as have the "priced
for bankruptcy" stocks, including the banks. Not all domestic
cyclicals are created equal. Performance of individual Topix
sectors during the rally to date indicates that pulp/paper,
textiles/apparel and chemicals lagged the aggregate indexes and
even the banks.
The banks themselves bottomed after the Topix and peaked before
the Topix peaked; they are indicative of a lagging, not a leading,
sector. The bank stocks were among the first to technically break
down after the recent rally. Indeed, if Topix-benchmarked
investors wanted to leverage a rally in Japanese equities, the
obvious choice would be the securities companies, the Topix
subsector index of which has soared 74.2 percent from lows in April
This is why Money Watch named broker stocks like Nomura as candidates
to leverage a Japanese rally when we suggested that Japanese stocks
could rise as the fighting began in Iraq.
Individual Japanese investors, on the other hand, have been actively
trading online and have recently taken more of a leadership role in
stock price formation. According to a director of Matsui Securities,
individual investors are looking for stocks with high dividend yields
(at least 3 percent), price earnings ratios of under 20 and price-book
ratios of less than 1, in addition to a management reputation for
treating shareholders well. This definition largely fits the "Dogs of
the Nikkei" group that Money Watch highlighted two weeks ago.
Tokyo Stocks Will Take Nasdaq's Lead
Like the bank subsector index versus the Topix, the Nikkei 225
and the Topix indexes bottomed out after the Nasdaq in this rebound,
but topped out first. Rather than market leadership, this suggests the
move in Japan was predicated on the rally in US equities. Money Watch
believes the recovery in the Japanese economy will be very mild at
best, and while there is progress in bottom-up restructuring, as is
indicated by the mixed picture in the electronic majors, this is very
much an issue of individual trees rather than the whole forest. Given
the choice between whole forests, Money Watch would still choose the
US forest over the Japanese forest -- as the fact that the rally in
the US has begun from a historically high level in terms of trailing
PERs says as much about the sustainability of the rally in Japanese
stocks as it does about the sustainability of the rally in US stocks.
Like it or not, the US is still the leading market, and if it is due
for an extended consolidation, Japan will follow.
-- Darrel Whitten
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