J@pan Inc Magazine Presents:
M O N E Y W A T C H
Weekly Financial Commentary from Tokyo
Issue No. 58
Tuesday, December 23, 2003
Editor's Note: This is the last Money Watch of 2003. We'll take a
two-week break and be back after the new year. Happy holidays to all
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++ Viewpoint: Onward and Upward to 2004?
The Bottom Line:
o From a top-down, big-picture perspective, the dollar -- and by
default, the strength of the yen -- is *the* asset global
allocation issue in 2004, and it could continue to be for the
next several years. The dollar allergy is here to stay.
o In 2004, the yen could appreciate to 80 yen to the dollar. The
strong yen could squeeze 1 percentage point of growth from
Japan's economy. This implies that the consensus of around
2.6-percent growth within the Bank of Japan (BOJ) is too high,
and the government's 1.8-percent growth rate may also be too
high. Japan's economy will continue to be driven by external
demand in 2004. The misperception is that this demand is being
driven by the US. In fact, it is being driven by increasingly
indigenous demand in Asia and China, while exports to the US
o Financial-sector fragility should continue to mend in 2004,
meaning no new March or September crises. But there still is a
lot of cleaning up to do in the regional banks, and the major
banks will continue to incur unusually high credit costs as
they move to pare down nonperforming loans from smaller
companies. They also have yet to seriously address the longer
term issue of just how they will make money and produce
shareholder returns comparable to their global peers.
o Global central banks may have to change gears and "normalize"
monetary policy in 2004, but it is probably too early for
Japan to follow suit. Investors will, however, remain leery of
unanticipated actions by BOJ governor Toshihiko Fukui, who
hasn't been doing the best job of developing good
communications with The Street.
o While world trade growth is expected to be strong in 2004, the
rising yen will hamper the relative performance of blue-chip
export companies. The last spurt through 100 yen will be the
most psychologically damaging. Wait for the yen to peak before
becoming aggressive on blue-chip exporters.
o Pricing power for basic material stocks will continue to
improve, driven by demand in Asia and China. In addition,
basic material stocks tend to perform better earlier in the
year. The shipping companies are also benefiting from Asia
trade and a strong recovery in global trade.
o In the US, the old economy mining, coal, steel, nonferrous
metals, aluminum, shipping, heavy machinery, industrial
equipment and paper products are leading the Dow Jones sector
indexes not only over the last quarter, but over the last
month. By the same token, the outperformance of shipping,
oil/coal, pulp/paper, iron/steel, glass/ceramics and
nonferrous metals seen in Japan's market over the last three
months could continue through the first half of 2004.
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++ Viewpoint: Onward and Upward to 2004?
"Japan's economy is recovering gradually," the BOJ states in a recent
report. "Exports are increasing, and private capital expenditures
continue to recover gradually. Industrial production is also
increasing, corporate profits are on an uptrend, and business
sentiment continues to improve."
"On the other hand, private consumption is virtually flat, while
the decline in household income is gradually abating," the central
bank continues. "Conversely, housing investment is sluggish and public
investment is declining."
"Looking forward, Japan's economy is expected to gain cyclical
momentum for a recovery in the second half of fiscal 2003, and it
will continue to recover during the course of fiscal 2004.
Overall economic activity deviates slightly above from the
standard scenario presented in the 'Outlook and Risk Assessment
of the Economy and Prices' (April 2003)," the BOJ concludes.
Some foreign observers (such as John Makin of the American
Enterprise Institute, as quoted in the Nikkei Financial Journal)
see Japan's economy decelerating back into its malaise in the
coming months, from unadjusted 3.5-percent real growth in the second
quarter of 2003 to an adjusted 1.4-percent in the third quarter, and
to zero or a GDP contraction in the fourth quarter. Because the
recovery is so dependent on external demand, goes the reasoning, a
slowing in the US economic recovery to 3.0-percent growth in the
fourth quarter will mean slowing exports and in turn lower GDP growth
Keep in mind also that Japan was supposed to have fallen off the
financial cliff sometime late in 2002, according to Adam Posen of
the Institute of International Economics, and others. A heavily
indebted Japanese government supposedly would be no longer able
to forestall bank runs by throwing money at the banks and the
stock market without also inducing panic in the bond market. All
it would take for the system to be overwhelmed was some
unforeseen external shock.
While even domestic academics were suggesting a similar fate, Japan
has exhibited an ability to take things to the brink several times
without actually falling off the cliff. Indeed, the closest (and it
was very close) Japan actually got to financial meltdown was in the
fall of 1997.
For fiscal 2004, the Japanese government itself is budgeting a
"conservative" 1.8-percent real GDP growth rate. The projected growth
would mark the third straight year of expansion, following a revised
real 2.0-percent GDP growth forecast for the current fiscal year
through March 31. In nominal terms, the world's second-largest economy
is expected by the government to grow 0.5 percent in fiscal 2004,
following a revised 0.1-percent rise in the current fiscal year.
When compared to the bearish outlook of some observers, the
government's own GDP forecast and the conservative forecasts of
domestic think tanks, the BOJ's numbers look positively rosy.
2003: A Year of Positive Surprise
As 2003 began, market sentiment globally and particularly in Japan had
reached new lows. The US downturn was not responding to historically
high levels of fiscal and monetary stimulus, there was again armed
conflict in the Middle East, and the SARS epidemic was ravaging Asia.
But as is always the case, the powerful rallies seen for the
remainder of 2003 had their seeds in the tsunami of bearishness
in the first quarter of 2003. US stocks and all global equity markets
staged powerful rallies in advance of positive economic surprises in
the US. In Japan, the rallies occurred on the back of massive monetary
and fiscal stimulus that created an "excess liquidity" situation, the
likes of which had not been seen since the Y2K debacle, and central
bank efforts to provide for any problem threatening the financial
system with mountains of liquidity. Last April, investors in
Japan were still steeling for a "hard landing" in the financial
sector as promised by Heizo Takenaka, newly appointed head of the
Financial Services Agency, and another flat-to-down year in
Japan's GDP as domestic deflation ravaged the economy. This glum
view was reflected in the BOJ's April internal consensus numbers.
In retrospect, central banks (led by the US Federal Reserve) and
governments had provided more than sufficient ammunition for a
virulent liquidity-driven rally, given the right catalyst. Investors
had discounted the worst to the second derivative, and all that was
required was a modest perception shift. Investors then scrambled
to redress oversold equity positions as equity markets surged,
producing a very nice rally in global equity markets for 2003.
This sudden shift in investor sentiment was nowhere more apparent
than in Japan. The bond market was discounting deflation for the
next decade in Japanese government bond (JGB) yields, heavily indebted
companies were being priced for bankruptcy (under 100 yen per share),
and the banks were getting pounded.
But given a new historical low of 7,600 on the Nikkei index,
Japanese stocks were seriously oversold, especially if one assumed
a) Japan's financial system was not as endangered as was
feared in the last quarter of 2002 and the first quarter of
b) Japan's economy had the capacity to grow above 2 percent on
a rebound, and
c) The ongoing restructuring within Japanese companies was
finally beginning to translate into improved profit margins
and could leverage even modest sales growth into two-digit
The bailout of Resona Holdings in May was the confirmation that
foreign investors needed to be completely convinced that Heizo
Takenaka and Japan's financial regulators would not pursue a
hard landing course so far as to push Japan into a deflationary
2004: Can the Equity Recovery Continue?
In many respects, the easy money was made in 2003. Global equity
markets and the Japanese equity market in particular recovered from
overly bearish expectations supported by massive liquidity. In 2004,
it will be trickier. If the economic recovery is indeed sustainable
and not a flash-in-the-pan like the last two, the BOJ will at some
point have to engineer an "exit strategy" from the zero-interest-rate
policy in place since the near-meltdown in 1997. Monetary and other
policies will have to smoothly evolve from "extraordinary measures"
mode and attempt to return to normalcy.
Normally, a shift in gears from a liquidity-driven market to a
fundamentals-driven market involves an interim correction, even
if the economic recovery is sustainable and equities are well-
supported by earnings fundamentals. This implies that the current
correction in Tokyo equities could linger into early 2004 even
if the recovery is sustainable and that earnings fundamentals
will become the new driver for stock prices.
Major Risk Factors for 2004
1) The dollar
From a top-down, big-picture perspective, the dollar (how far, how
fast?) -- and by default, the strength of the yen -- is *the* asset
global allocation issue in 2004 and could continue to be for the next
There are those who already predict that the days of the US dollar as
a global fiat currency are numbered and that gold could one day in the
conceivable future be trading at over $3,000 per ounce. Money Watch
finds these dire predictions of a US dollar collapse just as alarmist
as the predictions in 2002 that Japan's financial system was on the
brink of collapse, and with it, the yen's value against its major
Indeed, given the massively oversold position of the US dollar at
present and the straight-line projections of ever-spiraling twin
deficits in the US (d$BqK!&(Bvu 1980s), we may even see a modest rally in
the US dollar sometime in 2004, even if it is within the context of an
ongoing secular bear market.
But given a US current account deficit of 5 percent of GDP and net
liabilities of over 25 percent of GDP, the structural pressure on the
US dollar remains downward. It would take approximately a 34-percent
decline in the trade-weighted US dollar to reduce the US current
account deficit to a more manageable 2 percent of GDP.
Then the euro would be more than 1.60 to the dollar, and the yen would
be back at 80 yen to the dollar, a recipe for deflation in the
Eurozone and even deeper deflation in Japan.
A 10 yen per US dollar appreciation on an annual basis would trim
Japan's GDP growth by over 1 percent, significantly hampering economic
growth in 2004. Moreover, the stock prices of Japan's export
sector extrapolate current yen-dollar levels real-time and discount
the impact the currency has on reported profits, despite the fact that
the real impact comes six months to a year later. Consequently, the
final spike in the yen against the dollar would probably produce the
most downside pressure on stock prices of major exporters such as Sony
(code: 6758), Canon (7751), Toyota (7203) and Honda (7267).
Ironically, this would in fact be the time to most aggressively
buy these companies, given the very high projected growth rates in
global trade that institutions such as the OECD foresee.
2) Oil prices
A study by Dresprong, Maat and Jacobson at the Erasmus University
School of Management in Rotterdam called "Striking Oil: Another
Puzzle" finds strong evidence that changes in oil prices forecast
Oil is such a significant international commodity that economic
growth forecasts are invariably predicated on assumptions for oil
prices. The authors found that changes in oil prices strongly
predict future stock market returns in many countries and that the
impact of this predictability on stock returns tends to be large.
Stock prices tend to be lower after oil price rises and higher if the
oil price falls, even over short periods of a month.
Moreover, this relationship is robust over time and cannot be
explained by other market effects.
Thus it bears close watching that oil prices are at nine-month
highs aided by an early winter hitting the US northeast and
falling US crude and natural gas inventories. Oil has jumped
around $3 per barrel in as many weeks. US crude inventories have
fallen for the last four weeks, dropping 11.6 million barrels
below a year ago, the lowest December level since the government began
tracking the data in 1982.
Moreover, oil prices have risen nearly 25 percent since OPEC's
September decision to cut supply by 3.5 percent, buoyed by
strong Chinese demand and repeated sabotage at Iraqi oil facilities.
Some OPEC ministers warn that the cartel may cut supply again in
February on fears of a surplus once demand declines
after the northern winter.
This move in oil prices does not bode well for performance of the
developed world's stock markets in the first few months of 2004.
In particular, stocks of cyclical services and cyclical consumer
goods -- automobiles, consumer electronics, where Japan's
best known blue-chip exporters dominate -- are two areas most
negatively affected by rising oil prices.
The falling dollar and rising oil prices are two of the risks the
BOJ refers to as "risk from overseas economies" in citing the major
factors that could derail Japan's economic recovery.
3) Misperceptions of growth dependency
As Money Watch has pointed out previously on several occasions, it is
a misperception that Japan's export recovery has been driven by US
demand. In fact, much of the export recovery is owed to strong demand
from Asia in general and China in particular, with only incremental
portions of this dependent on US demand.
For example, Japan's customs-cleared trade surplus in October
rose 20.4 percent year on year. Exports were up only 5.4 percent from
a year earlier and fell 2.8 percent from a month earlier on a
seasonally adjusted basis. Exports to China jumped 27.8 percent from a
year earlier, offsetting a 6.2-percent drop in shipments to the US.
Moreover, October marked the 10th straight month of decline in
U.S.-bound exports. Indeed, Germany has recently surpassed Japan
as a major exporter to the US, while a significant amount of
exports to China are actually being consumed within China, not
being merely re-exported to the US.
Consequently, a slowdown in US demand for imports does not
necessarily mean a major re-think of Japan's export-driven economic
fundamentals, as long as Asia and China demand remains unaffected.
As the Dow perks up while Nasdaq waffles, some are calling for a
rotation from the tech stocks to "old economy" blue chips. In fact,
this has been happening all year, notwithstanding a brief pick-up in
tech. A look at the Dow Jones sector performance shows this very
clearly. The gainers for the year to date, the past three months and
the past month in the US are very much old economy stocks -- mining,
nonferrous metals, steel, coal, aluminum, shipping, heavy machinery
and industrial equipment. We believe this trend is likely to persist
through at least the first half of 2004.
In addition, Japan's basic materials manufacturers are much more
leveraged to Asian growth than its traditional exporters are.
This includes steel companies such as JFE Holdings (code: 5411),
Nippon Steel (5401), machinery companies such as Hitachi Construction
Machinery (6305) and Komatsu (6301), nonferrous metal companies such
as Sumitomo Metal Mining (5713), and shipping companies such as Mitsui
3) Financial sector risk
The IMF in its September financial-system stability assessment of
Japan maintained that the "financial sector remains weak
notwithstanding a series of policy measures. The capital position and
profitability of banks and life insurers (remain) weak, and NPLs
(nonperforming loans), although declining, remain high." This
notwithstanding, the differing pattern of how the financial
authorities dealt with Resona Bank and Ashikaga Bank illustrates the
two-pronged approach being taken. Where it is perceived by the
financial authorities that there is systemic risk, bank management and
bank shareholders are likely to get a pass.
Where it is perceived that there is not risk to the financial system,
the model is different. Both management and shareholders will have to
bear the responsibility.
Whether the deflationary impact on the economy was larger with a
"hard landing" approach to a major banking group like Resona, or
with a bank that dominated a regional economy like Ashikaga is
debatable. The Financial Services Agency for its part will continue to
insist that each case is different, but the differentiated approach is
nonetheless pretty clear.
Money Watch agrees that the financial sector (including the banks and
the insurance companies) remains weak. However, financial sector
systemic risk has been significantly reduced and will continue to
improve as long as stock prices remain firm. The major issue for the
banking sector in 2004, therefore, will be the clean up of the
regional banks' NPLs and NPLs to small- and medium-sized
institutions. Since loans to small- and medium-sized companies
account for the bulk of outstanding loans, the major banks are
expected to continue incurring higher than optimal credit costs
of 150-160 basis points versus a more normal level of 50 basis points
for the foreseeable future.
They will also not receive much help from the Industrial
Revitalization Corp., whose corporate revitalization efforts continue
to be very modest.
Assuming that the financial authorities have learned how to
control financial sector systemic risk, the biggest issue facing
the major banking groups going forward is how to restore
profitability and competitiveness to world-class levels. Here,
there is much work to be done, and it is likely that it will be
many more years before profitability of the major banks is
comparable to their global peers, and among their domestic
nonfinancial peers as well.
2004: Japan Euro Plays?
In 2003, the US equity markets' dominance of global equities and
fund flows began to slip as the US dollar's attractiveness waned.
According to the World Federation of Stock Exchanges, the market cap
weight of all US exchanges (Amex, Nasdaq and NYSE) fell from 49.1
percent in March 2003 to 46.5 percent by the end of November.
Europe was the biggest beneficiary of the flow of portfolio funds
to other markets than the US, while the Asia-Pacific region, Japan and
other emerging markets also incrementally benefited.
This was despite Europe's economy as a whole being a noticeable
laggard in the current economic recovery. In dollar terms, the
increase in aggregate European market capitalization was better
than the US between January and November 2003 at a 34.9-percent
increase versus a 28.1-percent increase for the US. But as this gain
was in dollar terms, the euro's surge against the dollar was a major
factor boosting performance. By the same token, the 36.4-percent
increase in the Japanese market during the same period was also
significantly boosted by the yen's appreciation.
The Dollar Allergy
Investor surveys are indicating that investor bearishness
regarding the US dollar and stock markets is as strong as ever. The
question for 2004 is, where will the equity investor money go if it
leaves the US markets?
US-based investors account for between 50 percent to as high as 65
percent of total foreign buying of Japanese equities. Foreign
investors, in turn, have consistently accounted for roughly 50 percent
of the value of shares traded in Tokyo throughout 2003. The US
Securities Industry Association reports that the third quarter saw the
continuation of record purchases of foreign stocks by US-based
investors. In that quarter, they were net buyers of $25.9 billion of
foreign stock, and through the first three quarters of 2003, they have
bought $57.9 billion for a run-rate of $77 billion, well above a
decade-old record of $62.3 billion.
Yet the last week of December saw net foreign selling by foreign
investors. Proposed changes in the tax laws and pension system
have clear indications -- the tax burden on Japan's consumers and
corporations is set to increase. Moreover, as soon as it has a chance,
the government would also like to hike the consumption tax another
Japan's economy by OECD estimates is set to slow from 2.7 to 1.8
percent, while Euroland GDP is set to accelerate from 0.5 to 1.8
percent and on to 2.5 percent in 2005. If these estimates prove to be
generally on the mark in 2004, the incremental fund flow will be to
Europe, not Japan, implying that, while no serious sell-off is in the
cards, the kind of gains seen in 2003 are not likely to be repeated.
This means that investors will have to be much more selective in
2004 than they were in 2003. Exports to the US will be inhibited
by continued strength in the yen against the dollar. Conversely,
the yen is now depreciating against the euro.
Thus, given the strong growth in world trade, vis-$B!&(Bvis a
falling dollar, US exporters should benefit handsomely given
their global competitiveness. At the same time, there are some
Japanese companies that have a higher weight of exports to Europe
as opposed to the US. These include companies such as bicycle
components producer Shimano (code: 7309), Pioneer (6773), Kuraray
(3405), Seiko Epson (6724), Shinetsu Polymer (7974) and car stereo
maker Alpine (6816). These companies would benefit from increasing
global trade, particularly that trade with the euro area, as the yen
weakens further against the euro.
-- Darrel Whitten
The International Secondary School
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