J@pan Inc Magazine Presents:
M O N E Y W A T C H
Weekly Financial Commentary from Tokyo
Issue No. 47
Tuesday, October 7, 2003
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++ Viewpoint: Extended Correction Averted by Good Economic News
The Bottom Line:
Top-Down: The US jobs report saves the day.
o The US jobs report came at just the right time, perhaps
representing an inflection point in investor perceptions and
preventing an extended consolidation in US stocks.
o The numbers helped alleviate concerns of a "jobless" recovery,
and worked to offset the negative surprise from the Group of
Seven pronouncement, thus helping to support the dollar. Like
the increasing number of other positive surprises, it is more
indication that the US recovery is gaining steam.
o There is good news in Japan, too, but domestic investors are
just not buying the "Japan is back" thesis. Institutions
(including the proprietary trading accounts of the brokers)
have been net sellers of equities, and while individuals are
actively trading, they too have been net sellers since April,
according to Tokyo Stock Exchange data.
o The increasing US dependence on foreign capital to fund twin
deficits will continue to haunt the dollar, despite increased
confidence in the economy. And while the Bank of Japan
continues to pour trillions of yen into the currency markets
to keep the yen from reaching the 100 yen/$1 milestone, it
appears to be fighting a losing battle.
* Bottom-Up: The currency risk for Japanese stocks continues, but the
small caps should be unfazed.
o There is continued currency risk for Japan's exporters, which
were budgeting an average of 115 yen to the dollar. During the
recent correction, this worry hit the Topix core 30 stocks the
o On the other hand, the small cap stocks remain unfazed by such
worries. Jasdaq continues to print new highs, supported by
active online trading by individuals. As long as the positive
bias regarding Japan's economy and Japanese stocks endures,
the small caps as represented by Jasdaq should continue to
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++ Viewpoint: Extended Correction Averted by Good Economic News
Having swallowed a good deal of the US economic recovery story
without a sizeable chunk of evidence, stock and bond investors
were having some serious second thoughts. And with policy missteps
aimed at getting China to devalue the yuan, the US dollar's apparent
renewed sell-off made investors absolutely nervous.
Since the US recession supposedly ended in November 2001, economists
have been looking for a recovery. But they have been equally reluctant
to give the "all clear" sign. The exogenous "shocks" of the last three
years -- the September 11 terrorist attacks, the Iraq War and the
Enron as well as other accounting scandals -- have made forecasters
gun shy. Consequently, the US market has been climbing a wall of
1. The current rally has begun from the highest trailing
price/earnings ratios on record.
2. The US has rapidly swung toward ballooning trade and fiscal
3. The dollar has already declined significantly, both nominally
and on a trade-weighted basis. While this is ostensibly
positive for corporate profits and US exports, too sharp a
dollar fall would have foreign investors packing up their bags
of money and going home, leaving the US in a pickle regarding
its substantial deficit-funding needs.
4. Bond yields have backed up sharply, and this could potentially
threaten any recovery, particularly hitting durable goods and
5. The budding recovery has not led to job creation so far. This
could strangle any consumption-led recovery.
But it's beginning to look like stock prices were more right than
wrong after all. The US and global economies increasingly look like
they are turning the corner. Despite much hand-wringing by cautious
investors, the economic numbers are coming through just when it seems
the market rally needs them most and are more consistently surprising
on the upside, which is typical in the early stages of a recovery.
The Commodity-Price Rally Continues
The rally in commodity prices, which bottomed in late 2002, began amid
a raging debate about encroaching global deflation. Futures prices of
Brent crude oil bottomed at $16.65 a barrel in late 2002, then surged
107 percent to $34.55 a barrel this March. The oil-price surge was
first attributed to concerns that military action in Iraq could
disrupt world oil supplies, but Brent crude oil prices have tested
downside resistance at $24 a barrel five times since 2002 and are
currently trying to rally above $30 a barrel.
Gold prices rose 41 percent from late 2002 to March 2003, ostensibly
on global geopolitical tensions and the falling dollar. But even after
bond yields reversed and stock prices surged, gold continued to rally.
Numerous studies on the link between gold prices and inflation
expectations show that gold has no particular significance for
forecasting inflation, but it is a leading indicator for other
industrial commodity prices, the rallies of which are another
indication that a global economic recovery is under way.
The rally in industrial metals reflected the fact that, by
mid-August, reports were filtering out that US industrial output
had recorded in July its biggest gain since January, marking the
third increase in a row and pleasantly surprising consensus
forecasts. By late August, economists were raising US growth forecasts
for the third quarter to as high as 7 percent, or more than twofold
growth levels in the preceding quarter.
The Economic Cycle Research Institute's leading index hit a record
high of 129.5 in the week of September 12. The index's growth rate, an
annualized rate for the four-week moving average that evens out weekly
fluctuations, has slowed somewhat in the latest reading, but the
institute says that "we should be prepared for above trend US GDP
growth for the next couple of quarters."
The US Jobs Surprise
This US recession, which began in March 2001, has seen the longest
slump in the US labor market since World War II, with a loss of 2.7
million jobs. This had economists fretting about a "jobless" recovery.
But the latest US payrolls announced in the US on Friday for September
showed the first gain in eight months, defying forecasts of more job
losses. While economists are still leery of calling this solid
evidence of a self-sustained recovery in the US, it does indicate that
even the labor market, a lagging indicator of any recovery, is showing
signs of bottoming out.
At the same time, the Institute of Supply Management showed numbers
indicating that the service economy was expanding at its second-
fastest pace in September for its sixth consecutive monthly gain.
Anything that bolsters confidence in the US recovery helps to
support the US dollar, which had been supported by a strong
domestic economy, an inviting investment climate and competitive
markets. If the US has actually abandoned its "strong-dollar policy"
(as some claim and as outlined by Money Watch last week) to stem
criticism of the Bush administration from Congress and US
manufacturers, it is playing with fire. This is because the policy,
without the support of a strong domestic economy, is an emperor with
However, evidence that the recovery was beginning to generate an
improvement in the job market was seen as an inflection point for
more stable economic growth ahead, and this helped to alleviate
the concerns raised by the Group of Seven pronouncement. Gold, the
mirror image of the US dollar of late, reflected the shift in
sentiment that the good news on jobs caused among currency traders.
But as outlined last week, the specter of a dollar rout will continue
to haunt the US market unless the US can get a handle on the renewed
surge in deficits. It is widely recognized by the International
Monetary Fund and domestic organizations like the National Association
for Business Economics that the soaring US budget deficit will remain
America's chief risk, although the threat is more relevant to US
long-term growth than to this current recovery. Indeed, the growing US
dependency on foreign capital has not gone unnoticed by the larger
capital providers. The front page of the Sunday Nikkei carried an
article outlining the soaring US dependence on foreign capital to fund
its deficits and the growing dependency in the corporate bond and
stock markets. The foreign dependency for US treasuries has soared
from under 20 percent in 1994 to 35.6 percent.
Of all the worries that US stocks continue to face, a falling dollar
still represents the biggest potential risk.
Japan's Economic Surprises
Fears of a "March crisis" and further problems in Japan's financial
sector until May (when Resona Bank was nationalized) overshadowed a
developing pattern of upside economic surprises for Japan as well. The
October-December gross domestic product (GDP) surprised with
stronger-than-expected capital expenditures and exports supported by
Asian demand. The June tankan, a quarterly business survey released by
the Bank of Japan, reflected a surprisingly large improvement in
business sentiment, particularly among small- and medium-sized
manufacturers, whose confidence showed the first improvement since
The April-June GDP indicated annualized growth of 2.3 percent, and
consumer spending actually rose despite consensus expectations for
declines. Household spending rose for the first time in nine months.
The jobless rate declined to 5.1 percent in August, and the Tokyo
consumer confidence index also improved for the second consecutive
Reflecting the improvement in business sentiment, the September
tankan survey showed the diffusion index of business sentiment
among large manufacturers at plus one, turning positive for the
first time in two years and nine months. But the survey did not
include reaction in the business community to the yen's renewed
Three main issues that could derail Japan's budding recovery continue
to bother domestic investors:
1. There is a fear that the strengthening of the yen cannot be
contained by record interventions by the Bank of Japan in the
2. They also worry about a rise in interest rates being much
faster than recovering corporate profits can absorb.
3. Business sentiment among non-manufacturers and smaller
businesses could continue to be weak.
Mixed Signals in the September Tankan
Business sentiment among automakers, electronics companies and
other exporters improved noticeably in the September tankan, as
much of the economic recovery is being led by exports.
But most large manufacturers assumed that the dollar would average
around 117.5 yen in the second half of the fiscal year, a level some 7
yen weaker than current exchange rates. In addition, Japan's exports
stopped growing in August, shrinking by 3.5 percent in volume. The
industrial production index also sank 0.5 percent from the prior
month, down for the first time in two months. Large manufacturers plan
to expand capital spending this fiscal year, but they revised their
spending forecasts slightly downward from the previous survey to an
Rising interest rates will also weigh on businesses, and many large
corporations expect them to climb further. The tankan revealed that
small and midsize firms are increasingly worried about a future
increase in interest rates on loans. Additionally, companies generally
share the view that they will face greater difficulty in procuring
funds as financial institutions become less willing to extend loans in
their continued push to clean up their own balance sheets.
Compared with large manufacturers, which are supported by strong
exports, business sentiment is weak among non-manufacturers that are
relatively dependent on domestic demand, with the index for the latter
group standing at minus 13, unchanged from the previous survey. In
particular, business sentiment among retailers and transportation
firms deteriorated sharply due to slack personal spending and the cool
The thesis behind the huge amounts of foreign investor funds
pouring into Japanese equities from April of this year is that:
1. Markets in the Western economies will remain in a "going
nowhere" pattern in the coming years as there is a massive
transfer of wealth to Asia.
2. The dollar is due for a major secular correction that will
reduce total returns on US assets to foreign investors.
3. Japan is showing all the characteristics of a secular bear
market low and is priced relatively cheaper than Western
4. The Japanese market now warrants and overweight position
vis-・vis global and international benchmarks.
In this cycle, foreign investors have been net buyers of Japanese
equities for six consecutive months and have made net purchases
of 5.2 trillion yen between April and September, with August being
the month of the highest net purchases, at 1.301 trillion yen. This
compares to the record of monthly net purchases of 1.75 trillion yen
set in March 1999. The inrush of foreign funds has made Japan the
best performer of the major countries in dollar terms for the calendar
year to date, but it still lags behind the others in terms of a
12-month performance, according to the Dow Jones dollar-
denominated country indexes.
As far as purchase cycles go, foreign investors have (during the
Heisei Malaise) been net buyers for up to 18 consecutive months, as
was seen in the telecom-media-tech bubble in 1999-2000. But for all
this newfound optimism, domestic investors have all -- including the
proprietary trading desks of the brokerage firms -- been net sellers
during this period. In other words, there has been no net buying
support at all from domestic investors, even though there is very
active trading by individuals through online brokers. In other words,
domestic investors just aren't buying the foreign investors' bullish
But neither the sharp backup in interest rates nor soaring equity
prices appear to have drawn significant amounts of domestic funds from
bonds into stocks, nor have the weakening dollar or rising domestic
stock prices tempted domestic institutions to significantly shift from
dollar-denominated offshore investments and domestic bonds into
domestic equities. While some funds in foreign equities were
repatriated back to Japan, funds continued to flow outward into
foreign currency-denominated bonds, mainly US treasuries, with the net
outflow being 9.68 trillion yen versus net inflows into Japanese
stocks of 7 trillion-plus yen (to the last week of September). Indeed,
some domestic life insurers say that they would like to increase
their exposure to US treasuries.
The continued upward pressure on the yen despite massive intervention
by the central bank even after the Group of Seven pronouncement is
worrying to Japanese investors and corporations with significant
dollar exposure. The negative currency surprise hit Tokyo stocks
with a sell-off of several hundred points, pushing the Topix back
toward its 13-week moving average. The large cap stocks (the Topix
Core 30) took the brunt of the selling pressure.
The smaller-cap stocks, particularly the Jasdaq listings, continued to
record new highs. Active trading by individual investors supports
Jasdaq. Back in May, we said that Japan's small caps were the sector
of preference, and they have so far lived up to our expectations,
despite the skewed weighting of a few "large cap" companies in the
-- Darrel Whitten
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