J@pan Inc Magazine Presents:
M O N E Y W A T C H
Weekly Financial Commentary from Tokyo
Issue No. 67
Thursday, March 11, 2004
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++ Viewpoint: Japan's New Secular Bull Market
The Bottom Line:
o As anticipated in Money Watch No. 61 back in January, the US
dollar has rallied some 6 percent. Even if it is only a rally
in a secular bear market, it could nevertheless make a try for
its 200-day moving average, which would represent a 10-percent
rally. The dollar has recently breached the 111-yen level,
which may trigger more dollar short covering.
o The dollar's rebound has led to a spurt of strong performance
by the Tokyo market on very strong trading volume. Both
Japan's economy and stock market have overcome the flat spot
seen in the final months of 2003, and, as we pointed out in
December in Money Watch No. 57, the stock market has given a
clear answer to the "cyclical or secular" question. It's
definitely looking for a secular recovery.
o In fact, Money Watch believes that Japan's market and economy
are now emerging from the Heisei Malaise, as fears of a
financial sector disaster have been proven unfounded, and it
appears that the banking sector has turned the big corner. The
Koizumi administration can now point to the progress being
made in its so-called No. 1 reform priority: cleaning up the
banking sector. The Bank of Japan has also played its part
since Toshihiko Fukui became governor. They have shown no
hesitation in pumping up the monetary base in an attempt to
reflate Japan's economy, and it seems to be working.
o Moreover, the third step also appears to be emerging. There is
a visible broadening and deepening of the economic recovery,
aided by grass-roots restructuring and reforms in many
industrial sectors and among individual companies. Free cash
flow for Japan's larger companies has been positive since late
1993 and continues to improve. Consolidated pretax profits for
the current year through March 31 should rise by 21 percent,
while profits are expected to rise another 14 percent in
fiscal 2004 for the third consecutive year of gains. If the
current pace of improvement continues, these profit numbers
could prove conservative. The key will be maintaining the
reform and restructuring course even as business improves.
o Money Watch believes the surging trading volumes and the
movement in "late cycle" sectors such as real estate are clear
indications that the stock market is correctly reading that
Japan is making the big turn with the end of the Heisei
Malaise in sight. While it could prove problematic for the
Bank of Japan should end-of-deflation expectations run too far
ahead of actual fundamentals, Money Watch sees any sudden
back-up of rates as basically a short-term impediment to the
emerging secular bull market. Stock markets inevitably stage
an interim correction when shifting from excess liquidity to
economic and earnings fundamentals. As we expect both the US
Federal Reserve and the Bank of Japan to react very
cautiously to emerging signs of early inflation, the shifting
of monetary policy gears is seen as more of an issue for 2005
than for the remainder of 2004. Indeed, the April-June quarter
could see domestic financial institutions come out swinging in
the new fiscal year with increased allocations to equities.
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++ Viewpoint: Japan's New Secular Bull Market
Over the past year, Japan's Nikkei index has regained a degree of
vitality not seen for most of the Heisei Malaise. It took a couple of
months for the Japan market to right itself once the US market began
to rally in the first quarter of 2003. The Nikkei had bottomed out
during the week of April 28, over a month after the US equity indexes
hit bottom during the week of March 10. In local currency terms, the
Nikkei has outperformed the Dow Jones industrial average and the S&P
500 by 13 percent and 9 percent, respectively, during this rally. In
dollar terms, however, it has outperformed the S&P 500 by 38 percent.
The first major change of foreign investor sentiment regarding Japan
was the replacement of Bank of Japan governor Masaru Hayami with
Toshihiko Fukui. Fukui gave the impression to both the Japanese
government and investors that he would be much more flexible regarding
"unconventional" monetary policy. During the first days of his tenure
as BOJ governor, Fukui gave foreign investors the impression that the
BOJ was about to embark on a more aggressive reflation stance. The de
facto nationalization of Resona Bank by the government in May was
taken as a resolute attempt by Japan's banking regulators to: a)
continue pressuring the banks to clean up their nonperforming-loan
(NPL) problems, and b) ensure a soft landing. It marked a major
turning point in the growing fear among domestic politicians and
investors that Heizo Takenaka, appointed as the new Financial Services
Agency minister in September 2002, might force a hard-landing solution
on the nation's banks that could jeopardize any chance of an economic
These fears proved unfounded. The grim forecasts of a possible
collapse of the Japanese financial system, made regularly since
Japan nearly experienced a financial meltdown in late 1997,
rapidly lost their shock value as the signs of a revitalizing banking
sector become unmistakable. By December 2003, the program to reduce
NPLs at the major banks by half by March 2005 was progressing "quicker
than expected," according to Takenaka. Japan's leading banks now plan
to return to the black in the current fiscal year. Many financial
holding companies have even raised their profit expectations
considerably in the meantime. The encouraging progress being made in
trimming the bad loan portfolio has been recognized by the rating
Many domestic critics and investors claim that prime minister Koizumi
has been long on talk but short on execution as regards his reform
initiatives. However, one of Koizumi's actions was to consolidate
fiscal and economic policy under one organization, the Council on
Economic and Fiscal Policy, thereby wresting de facto control of
economic and fiscal policy from the hands of the bureaucrats and
introducing private-sector expertise into the policy decision process.
When the Koizumi administration's basic platform of structural reform
policies was announced in June 2001, it clearly stated that the first
step toward economic revival for Japan would be the definite and final
disposal of bank NPLs and a stabilization of Japan's financial system.
With the major banks now expected to meet their NPL ratio targets by
the stated cut-off date, the Koizumi administration appears well on
its way toward achieving the stated No. 1 priority of its original
reform program: stabilization of Japan's banks and banking system.
Even at the height of deflationary concerns in 2002, when investor and
political focus was on deflation and the negative implications of
Japan's being caught up in a deflationary spiral, the February 27,
2002, "Emergency Countermeasures to Deflation" policies essentially
renewed the Koizumi administration's focus on cleaning up the banking
sector and stabilizing the financial system as a means of addressing
the root cause of Japan's deflation.
To the Koizumi administration's detractors, this focus on cleaning up
the banking system was perceived as exactly the wrong thing to do. It
would exacerbate, not work to eradicate, deflationary pressures, which
seemed to be in 2002 on the verge of deteriorating into a deflationary
spiral, they argued.
But here is where the Koizumi administration's "pact" with Fukui at
the BOJ came into play. Instead of standing by and claiming that more
structural reform was required before the BOJ could implement more
aggressive reflationary measures, the BOJ under Fukui continued to
dramatically increase the amount of funds available to the banks in
the form of current balances at the central bank, which directly led
to substantial increases in Japan's monetary base. Historically, a
rapid rise in the monetary base has been accompanied by a rising money
stock (money supply), inflation and high nominal GDP growth. But
because of the banking sector's inability to perform its traditional
role as a money multiplier in the economy, the modest increases in
monetary base heretofore had not translated into either inflation or
improved economic growth. From July to November 2003, however, Japan's
monetary base was soaring by over 20 percent year on year as: a)
current account balances soared to over 30 trillion yen from one-digit
levels, and b) the BOJ and Finance Ministry were pumping over 27
trillion yen into the currency markets in support of the dollar, which
was also helping to boost the monetary base.
Japan's economic recovery was first dismissed as yet another
transitory phenomenon that was based mainly on exports. But as 2004
has progressed, there is increasing evidence of a deepening of the
recovery. October-December 2003 GDP growth was a big surprise,
clocking in at 7-percent annualized growth rates. The BOJ's December
tankan survey of business sentiment was already indicating better-
than-expected business conditions, with Japanese businesses being
more optimistic than they have been in six-and-a-half years.
Industrial production has been rising for over a year and has
recently accelerated to the 5-percent level. Meanwhile, inventory
levels continue to decline. Machinery order growth by the last
quarter of calendar 2003 had accelerated to high two-digit
levels. January economic indicators showed a coincidental index
of 77.8 percent (preliminary) for the ninth consecutive month,
following an apparent bottoming of the business cycle in January 2002.
The leading indicator also remained above the boom-bust line of
55.6 percent in January, trending over 50 percent for the fifth
straight month. More importantly, there are signs of life emerging
among Japan's beleaguered consumers. The BOJ's integrated retail sales
indicator jumped by 2.2 percent over the previous month in January and
has been in a mild recovery since last fall. Real household
expenditures during the month were also up 1.3 percent year on year.
The Finance Ministry's survey of incorporated enterprises indicates
that aggregate ordinary corporate profits for the October-December
period of 2003 grew by 16.9 percent year on year, after bottoming out
in late 2001 on declines approaching 40 percent. Moreover, the
cyclical recovery is being aided by significant improvement in the
earnings structure of companies. Operating profit and ordinary profit
margins for the large companies in the Finance Ministry survey of
incorporated enterprises (with capital of 1 billion yen or more) are
nearing levels not seen since the beginning of the Heisei Malaise as
companies have reduced debt, trimmed employment ranks, sold off or
closed unprofitable businesses and moved operations overseas.
Until fairly recently, investors could point to only a handful of
corporate restructuring success stories, and essentially all of them
were driven by foreign investment. However, domestic-domestic success
stories are also emerging. For example, JFE Holding's (code: 5411, the
product of a merger between Kawasaki Steel and NKK) West Japan steel
plant now has a gross margin of about 20 percent, or about two times
that of Toyota. Its expected ordinary profit this year is around 210
billion yen, or 50 billion yen higher than Nippon Steel's (5401).
Rather than becoming yet another merger disaster, the JFE Holding
merger is transforming two second-tier companies into a first-tier
global competitor. The company's engineers and salesmen are now
talking with each other, trying to figure out more ways to improve
profits. Interest-bearing debt for the group has been slashed by 40
percent from levels four years ago. As a result, the company now pays
a higher dividend than Nippon Steel and enjoys the largest market
capitalization in the steel sector, again surpassing Nippon Steel.
While Japanese companies are still reluctant to increase hiring,
there is evidence that investment in domestic plants, equipment
and even factory sites is recovering. In 2003, the number of sites
purchased for new factory construction increased for the first time in
three years to over 1,000 cases, according to METI. Moreover, a Nikkei
survey of large corporations last September indicated that overseas
capital investments in fiscal 2003 fell by 7 percent over the previous
year, indicating that Japanese companies are beginning to reconsider
the merits of producing in Japan. In other words, the "hollowing-out"
trend may be beginning to reverse. The driver of this U-turn
phenomenon is digital consumer electronics, such as flat screen TVs,
digital cameras, DVDs, etc. The number of cases of investment in
domestic factory sites rose 30 percent last year in the electric
equipment and precision equipment sectors, including Sharp (6753) for
LCDs, Toppan Printing (7911) for color filters, Nitto Denki (6988) for
polarizing film, Canon (7753) for digital cameras, Matsushita Electric
(6752) for DVD recorder LSIs, Mitsubishi Electric (6503) for
automobile engine components and Sanyo Electric (6764) for solar
A Nikkei survey of over 1,600 listed companies reporting in March
indicates that listed companies in all industrial sectors will mark a
combined 21-percent gain in consolidated pretax profit for the current
year through March 31, the first record high in three years. The
survey indicates aggregate pretax profit will rise another 14 percent
in fiscal 2004 for the third consecutive year of gains. Combined group
net profit will surge by more than 70 percent, with the recent stock
market pickup freeing companies from worrying about increased
appraisal losses on their stockholdings as in the previous year.
The recovery is being driven by a revival of manufacturing profits.
The manufacturing sector will score a 25-percent gain in pretax profit
on a 2-percent rise in sales, while non-manufacturers expect to see
earnings jump 15 percent through restructuring efforts. In particular,
electronics firms will post a 64% jump in aggregate pretax profit
thanks to robust sales of digital appliances. Automakers will see a
15-percent gain in combined pretax profit owing to strong sales
overseas and cost cutting.
There is increasing evidence that the current recovery is deepening
and will be more pervasive than any mere cyclical uptick in the Heisei
Malaise so far. Money Watch is convinced that Japan has turned the big
corner and is now well on it's way to escaping the Heisei Malaise.
Free operating cash flow for large firms, the real value driver behind
stock prices, first turned positive in late 1993 and has remained
positive throughout the Heisei Malaise. Balance-sheet and financial-
sector risk, however, more than offset this free cash flow until the
regulators and the banking sector began to get their arms around the
NPL problem, which was being exacerbated by tepid economic activity,
deflation, and falling stock prices. As the negative cycle of falling
prices, depreciating asset values and growing NPLs begins to reverse,
bankruptcy risk and financial-sector stability improves, allowing both
financial institutions and investors to become less risk adverse. The
"bankruptcy" and "growth" discounts disappear, and domestic investors
are able to begin shifting assets from bonds and bank deposits into
the stock market.
Foreign investors were into this "reflation" wave early, being net
buyers of 11.3 trillion yen of Japanese equities from April 2003. At
first, they were mainly redressing a substantial underweight position
in Japanese equities for global portfolios. Secondly, they were
diversifying from what was seen as a secular bear market in the US
dollar. Finally, they were buying on increasing confidence of a
sustainable turnaround in the Japanese economy and corporate profits.
So far, domestic institutions have used this foreign buying to unload
trillions of yen of their stockholdings. The banks were trying to get
their stockholdings below the level of their Tier 1 capital as
required by the Financial Services Agency, business corporations were
reciprocating by unloading bank stocks as well as selling
stockholdings in corporate pension funds in order to return the
management of welfare pensions from the corporations to the Government
Pension Investment Fund.
But if the Japanese market recovery is to become a sustainable secular
bull market, more active participation by domestic financial
institutions will be required. Domestic institutional investors
themselves must become convinced that Japan's economy and stock market
have entered a new secular recovery phase.
When this happens, domestic institutional investors could well become
the driving force of the next big upleg in the Japanese stock market
as they shift assets from an overwhelming preference for bonds and
fixed income into stocks. Indeed, a secular shift into stocks by
domestic institutions could well continue driving Japan's stock market
for the next few years. There is already sufficient trading volume to
support such a breakout. Trading on the Tokyo Stock Exchange has
recently hit levels not seen in 14 years -- a clear indication that
the stock market itself is already trying to discount the importance
of Japan's escape from the Heisei Malaise. From the onset of March,
daily trading value has hit the 1.5-trillion-yen level, the highest
volume of trading seen since the spurt during the IT bubble. Moreover,
sector rotation seems to be proceeding smoothly, in direct contrast
with the dramatic sector polarization seen during the IT bubble.
In terms of sectors, the clearest evidence of growing expectations for
an end to Japan's deflation nightmare is the strong rally seen in the
real estate sector. Real estate prices lag behind the stock market by
one to two years, so the strong rally seen in real estate stocks is in
the growing expectation that Japan's real estate market has also
bottomed out and is poised for the next secular upswing, a full year
after the stock market bottomed out and began to rally.
For the fiscal year to date, the real estate subsector of the Topix
has become the leading sector, soaring by over 100 percent compared to
a "modest" 44-percent rise in the Topix. It has even surpassed the
performance of the nonbank finance sector from the onset of 2004,
heretofore the darling of foreign investors. Conversely, "early cycle"
sectors such as iron/steel, nonferrous metals and other basic-
materials sectors have all but disappeared from the ranks of the
leading Topix subsectors and have largely ignored the strong rebound
seen of late in these sectors in the US market over the past month.
Another "late cycle," "end of deflation" sector to watch is retail,
which could benefit for the same reasons that the real estate sector
As pointed out last week, it could prove problematic for the BOJ
should end-of-deflation expectations run too far ahead of actual
fundamentals. While good for domestic-oriented sectors such as real
estate, it may encourage a "buyers strike" in the bond market, again
sharply pushing up bond yields at a time when the government would
rather keep interest rates as low as possible to facilitate increased
deficit-funding bond issues. Yet even the BOJ is finding it hard to
suppress a growing confidence in Japan's economy, which is being
reflected in its economic assessments.
-- Darrel Whitten
Money Watch No. 61 "Euro Rethink Will Help Japan":
Money Watch No. 57, "Secular or Cyclical?":
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