J@pan Inc Magazine Presents:
M O N E Y W A T C H
Weekly Financial Commentary from Tokyo
Issue No. 69
Tuesday, March 23, 2004
@@ VIEWPOINT: Terrorism, the US Correction and Japan
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@@ VIEWPOINT: Terrorism, the US Correction and Japan
The Bottom Line:
o The sad truth about the rise of global terrorism is that it
cannot be ignored and must be addressed, yet is difficult to
eradicate. For the financial markets, it is an unfathomable
risk that is difficult to quantify in terms of a risk premium.
It also involves substantial costs in fiscal terms, as the US
is finding out. As was seen in Spain, it can even change the
political balance of a nation.
o Terrorism risk is one factor bothering the US stock market.
The other is the focus on the lack of job creation in the
current economic recovery, which actually has investors in a
quandary. If current lackluster job creation continues, it
raises doubts about the sustainability of the US recovery and
apparently is making the presidential race so close that it is
hard to handicap, creating policy uncertainty. On the other
hand, accelerated job growth only hastens the day when the US
Federal Reserve will have to change its monetary policy
o Central banks, particularly the Fed, have laid the groundwork
for significant inflation once the economic recovery does take
hold. One only needs to look to the significant rises in all
manner of commodity prices to see that reflation is taking
hold and will eventually work its way into consumer prices.
Once inflation takes hold, it just can't be turned off
overnight. This implies an extended period of rising interest
rates that the US market is already trying to discount.
o Fundamentally, Japan's equity market recovery from the depths
of despair in April 2003 (when the Nikkei hit 7,600) has been
supported by: a) aggressive reflation efforts by the Bank of
Japan; b) the consistently tough attitude by the Koizumi
administration and the Financial Services Agency to keep up
pressure on the nation's banks to clean up their balance
sheets and reduce financial sector fragility; and c)
grass-roots efforts by Japanese companies to restructure and
reform their businesses to regain lost profitability and
global competitiveness. Any improvement in top-line growth
(which is already being seen) will flow almost unimpeded into
profit growth. There are even signs that manufacturing
competitiveness in some of Japan's most depressed
manufacturing sectors is recovering.
o Given a continued deepening of the domestic economic recovery
(to the point that it becomes a secular recovery), Japan is in
better shape to de-couple from a US stock market correction
than it has been at any time during the Heisei Malaise. As
Japan completely de-coupled from the historic bull market in
the US during the height of the Heisei malaise, it can also
de-couple from the current interim correction in the US market
and is better positioned to weather a strong yen as well.
o Thus, aside from underperformance in electronics, precisions
and autos -- three segments particularly linked to the
movement in US equities -- we see no serious impediments to an
ongoing equity rally in Japan.
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@@ VIEWPOINT: Terrorism, the US Correction and Japan
Since September 11, 2001, the US and its allies' struggle with global
terrorism has become front-page news. The struggle has exposed the new
threat to developed economies and societies: organized, dedicated and
global terrorism. National security is no longer defined by armed
forces standing between the aggressor and the homeland. Terrorists
supported by sophisticated planning and logistics and with access to
unconventional weaponry have changed the nature and the very
definition of war. The stakes in the international "war" on terrorism
have dramatically increased, while the margin for error in selecting
appropriate responses has diminished correspondingly.
The terrorist attacks in the US, Bali and Spain have had enormous
political implications. With the September 11 attack, the terrorists
awoke a sleeping giant (the US), who has since used every means at its
disposal to take the "war" to the terrorists, instead of passively
waiting and trying to anticipate the terrorists' next move.
The US victories were the overthrow of the Taliban government in
Afghanistan and Saddam Hussein's government in Iraq. Al Qaeda's
victories were 9/11 in the US, the withdrawal of the US from its
military bases in Saudi Arabia, and the turning of a US ally to a
socialist government in Spain. Politically, the Spanish bombings were
a massive al Qaeda victory. With one blow, it knocked a major US ally
out of the Iraq campaign and raised serious questions as to how far
Spain or indeed other US allies in the fight against terrorism will go
to support the US-led effort. Al Qaeda and its related terrorist
organizations now know that if they pull off some spectacular bit of
terrorism prior to an election, it is possible to topple a government
that actively opposes it.
Indeed, as the US and its allies close the noose ever closer on senior
al Qaeda operatives, a recent report by the French says that al Qaeda
is in the process of recruiting tens of thousands of European Muslims
and organizing them into military-type units. They reportedly meet
regularly under the auspices of innocent social organizations to train
for terrorism and the use of weapons and explosives. According to
European sources, between 35,000 and 45,000 individuals have been
recruited in France alone. In Germany, al Qaeda is estimated to have
added another 25,000 to 30,000 men, and another 10,000 have joined in
Britain. Numbers of enlistees in Belgium, Switzerland, Holland, Sweden
and Norway are unknown, but are thought to be significant. In other
words, the war is escalating.
The sad fact of life is that there is as yet no effective means of
eradicating global terrorism. The "hard line" approach as practiced by
Israel has not prevented constant acts of terrorism against Israelis
on a daily basis; the US war on terrorism has not prevented such acts
against their allies and leaves the US homeland at risk. Yet
appeasement is also not the answer. As Winston Churchill once said,
"An appeaser is one who feeds a crocodile, hoping it will eat him
The pragmatic answer is that terrorism has become a fact of life. The
ongoing and increasing risk of major acts of terrorism represent not
only an immeasurable risk to the financial markets, but also act as a
tax on economies in terms of the cost of attempting to protect and
defend against such random acts. This is particularly true for the US,
which has, because of its assumed role as the world's policeman,
assumed a heavy fiscal burden (and growing deficits) maintaining a
military and intelligence-gathering force around the world to hunt
down and ferret out terrorist threats. This "burden" is helping to
weaken the dollar and will act as a drag on US economic growth.
The US economy has been growing since the fourth quarter of 2001, yet
few jobs are being created. In fact, the US apparently lost 2.2
million jobs since 2001. As an article in The New York Times noted,
"At no other point since World War II has the economy grown for such a
long period without adding jobs at a healthy pace."
Such statements are misleading. While politicians like to blame this
on "offshoring," or replacing US jobs with those in countries with
lower wages such as India and China, this accounts for a far smaller
percentage than claimed. In this post-recession rebound, productivity
gains have been larger than normal, rising at an annual average of
about 4.5 percent, compared with the still-healthy 2.5-percent gains
in the late 1990s.
In addition, jobs in the US are coming back, but under the radar
screen, in small startups. This is why they are hard to count. When
the US government counts employment growth, it surveys established
companies. That's why it's called the "establishment survey." On the
other hand, the unemployment survey, the one doing so well now, is
based on a survey of households, not corporations. The White House
reported that 2003 saw a record number of sole proprietorships.
Organizations that consult with or offer education to those starting
entrepreneurial ventures say that they've never been busier. Maybe the
US economy is doing the same thing that it's done after every other
recession for the past 30 years, creating jobs faster than the
bureaucrats can count them. The data suggest that most of the jobs
added during the recovery have been new positions in different firms
and industries, not rehires.
The Federal Reserve Bank of New York's view is that this shift to new
jobs largely explains why the payroll numbers have been so slow to
rise: Creating jobs takes longer than recalling workers to their old
positions and is riskier in the current uncertain environment. The
bank also points out that, although the weak performance of the labor
market during the current recovery has been surprising, it is not
without precedent. The period following the 1990-91 recession was
dubbed the "jobless recovery" because the economy added so few jobs
during the first year-and-a-half after the expansion began.
"The current recovery parallels this earlier recovery in important
respects." the bank has written. "In 1991-92, output growth rose
fairly steadily, but job growth remained near zero for more than a
year. In 2002-03, real (inflation-adjusted) GDP has grown each quarter
at annualized rates between 1.3 and 5.0 percent, while payroll growth
averaged -0.4 percent at an annualized rate through July. Although the
job-market resurgence in the past may often have lagged behind the
output recovery by one quarter, only during the two most recent
recoveries has the divergence between job and output growth persisted
for a longer period. After about 18 months, the 1991-92 recovery
ushered in very strong employment growth and the longest economic
expansion of the postwar period. A preponderance of structural-- as
opposed to cyclical -- adjustments during the most recent recession
would help to explain why employment has languished during the
recovery. If job growth now depends on the creation of new positions
in different firms and industries, then we would expect a long lag
before employment rebounded. Employers incur risks in creating new
jobs and require additional time to establish and fill positions."
Is Job Growth What Is Really Bothering the US Market?
The S&P 500 is at 23.3 times earnings now, or above the average of
16.1X since 1946. But it is well below the average of 32.4X in 1999,
the year before the prior crash, and well below the high of 46.5X in
January-March 2002 following a collapse in corporate profits. Indeed,
the Fed model, the source of Alan Greenspan's infamous "irrational
exuberance" comments, now shows US stocks on consensus estimates at
some 33 percent undervalued relative to bonds. But individual investor
sentiment has now cooled to 58 percent versus a recent peak of 84.8
percent in January, according to the American Association of
Indeed, investor (particularly institutional) risk aversion has
risen in response to the terrorist attacks in Spain and mixed
economic news in the United States (read poor job numbers). In
addition, the presidential election has apparently become so
competitive that it is difficult to handicap, raising doubts
about future economic, tax, spending and trade policies.
Central banks, particularly the Fed, have laid the groundwork for
significant inflation once the economic recovery does take hold. Once
inflation takes hold, it just can't be turned off overnight. Reuters
CRB Index futures continue to set new highs and are now at their
highest levels since 1981. Oil prices are back up to US$34/bbl, while
copper and general commodity prices like those for soybeans continue
Indeed, the US market is now between a rock and a hard place. Rest
assured that companies will try to pass increasing basic materials
costs off onto their corporate buyers and eventually consumers as soon
as they are able. Investors should also be careful what they wish for
in terms of US job growth. If job growth were to actually accelerate
to the levels ostensibly needed by the Bush campaign to ensure
President Bush's re-election in November, the Fed would quickly change
its tune about being "patient" on interest rates and its monetary
policy stance. There lies the quandary: Lack of job growth raises
doubts about the sustainability of the economic recovery, while
job-growth acceleration only hastens the day when the Fed will have to
change its monetary policy stance.
As Money Watch has argued repeatedly, this transition will inevitably
involve an interim correction as equity and bond markets shift gears
from being driven by excess liquidity to earnings and economic
fundamentals. At the highest risk from this transition will be stocks
most leveraged to growth expectations: small and micro-cap speculative
growth, technology and biotech stocks. In the 1990 and 1994 bear
markets, these stock groups peaked years before the stock market and
formed mini-bear markets even as the overall US bull market continued
for the rest of the decade.
Increased risk aversion and a consolidating US market could also stunt
the Japanese market's recovery, especially since foreign investors
have provided the main source of buying for Japanese equities.
Fundamentally, Japan's equity market recovery from the depths of
despair in April 2003, when the Nikkei dipped to 7,600, has been
a) Aggressive reflation efforts by the Bank of Japan (BOJ),
which has allowed current balances held at the bank to swell
to over 30 trillion yen, while at the behest of the Finance
Ministry, it has massively intervened (also in excess of 30
trillion yen) to cap the yen's rise.
b) A consistently tough attitude by the Koizumi administration
and the Financial Services Agency to keep up the pressure on
the nation's banks to reduce nonperforming loans, while at the
same time standing ready to nationalize any institution that
may present a threat to the stability of the financial system.
c) Grass-roots efforts by Japanese companies to restructure
and reform their businesses to regain lost profitability and
Each new batch of economic numbers and statistics gives further
evidence of a deepening of Japan's economic recovery. For example, the
coincidental economic indicator for January was revised upward to 80
percent, representing the ninth consecutive month above 50 percent.
Factory operating ratios, a proxy for manufacturing operating profits,
were at 103.0, versus 99.8 three months prior. The BOJ revised upward
its view of personal consumption and capital expenditures in its March
monthly review of economic and financial conditions. The Cabinet
Office's "Business Condition Watcher" survey is showing solid
improvement in sentiment regarding employment conditions.
There are even signs that manufacturing competitiveness in some of
Japan's most depressed sectors is recovering. Japan's steel producers
-- after many years of successive restructuring and downsizing -- are
enjoying profitability not seen in a decade. Over the last decade,
most knitwear sold in Japan was provided by imports. According to
trade statistics, imports of knit outerwear from China, the biggest
knitwear exporter to Japan, now stand at some 1.2 billion units a
year, or about 570 billion yen. The amount is equivalent to 30 percent
of Japan's total textile product imports from China and more than 80
percent of the country's total knit outerwear imports from all over
Meanwhile, domestic production of knitwear has shrunken to 110 million
units a year, as new retailers like Fast Retailing (9983) built their
business models on importing cheaply produced garments from China.
Even domestic knitwear textile producers are starting to make a
comeback. Onward Kashiyama (8016) plans to shift up to 10 percent of
knitwear production back to Japan following the development of a
production system enabling it to lower domestic production costs to a
level on a par with China. The introduction of whole-garment knitting
machines is reviving domestic production. Sanyo Shokai (8011) already
produces 20 percent of its domestically made luxury knitwear using
whole-garment machines. Other apparel makers are also likely to start
producing mid-priced knitwear in Japan using whole-garment knitting
machines, which now enable them to turn profits on domestically
produced knitwear priced at 7,000 to 8,000 yen.
The Japanese stock market's strength in the first quarter of 2004 was
already a vote for the sustainability of the Japanese recovery. It is
increasingly being perceived as being driven by structural improvement
in the domestic economy and not merely exports. The growing confidence
in a secular recovery is reflected in the expected recovery in
corporate profits, which is increasingly being seen as more than just
a two-year cyclical wonder.
By the time this is published, the government will have released
assessed property values for 2003, where investors will be keying on
the trend in Tokyo property prices for hints that the long draught in
property values is finally ending. Since property values lag behind
the stock market by a considerable margin (one to one-and-a-half
years), good news on property prices will confirm that the worst has
already been seen there. Also, keep in mind that government-assessed
property values trail actual selling prices, where anecdotal evidence
suggests the turnaround is already forming, albeit in a selective
fashion. Because of Japan's adverse demographics (which for the time
being will continue to get worse), Japan's property markets are
expected to become ever more polarized as the recovery evolves.
The next data point will be on April 1, when the BOJ announces its
latest tankan survey of business sentiment. The surprising strength of
the previous tankan was one factor that helped to change bearish
market sentiment on Japan.
Finally, the next batch of earnings results should begin emerging from
late April. These results could well give further support for upbeat
aggregate earnings scenarios. While the sharp reversal in the recent
weakening of the yen is an impediment, the impact should only be felt
in selected export-oriented sectors and is not expected to seriously
hobble the equity market rally unless the yen shoots well beyond 100
to the dollar. Even then the adverse impact should only be temporary
as long as evidence continues to mount for secular improvement in
Japan's domestic economy and industries.
Both overseas and domestic investors have been keying on domestic-
oriented stocks almost from the onset of the current rally because of
uncertainties regarding the yen and the higher linkage to the waffling
US market. There are indications, however, of overheating in some of
the more popular domestic sectors.
For the fiscal year to date, the stock prices of four sectors have
essentially doubled: other finance, real estate, insurance and the
banks. The other finance sector -- consumer finance -- has long been a
favorite of foreign investors for the good growth prospects and
Prospects for the sector have recently brightened further with the
announcement that the Mitsubishi Tokyo Financial Group (8306), Japan's
strongest banking group, will be taking a 15-percent stake in Acom
Japan's major banks have finally swallowed their pride and admitted
that their efforts to grow their retail finance businesses have been a
failure. The major banks have long coveted the consumer-finance
companies' credit-assessment database and retail-finance risk-
management abilities. From the consumer credit companies' perspective,
an alliance with a major banking group would enhance their
creditworthiness and formalize low-cost credit lines. Aiful (8515),
Promise (8574) and Sanyo Shinpan Finance (8573) have also made no
secret of their wish to develop ties with major banking groups.
The performance of the retail sector and, more recently, the
construction sector is reflective of growing expectations that Japan
is nearing the end of its deflationary phase, while investor aversion
to weak balance sheets has waned as the perceived financial-sector
risk has abated. The newfound performance of warehousing/harbor is
also an indirect "end of deflation" play.
On the other hand, the sectors trailing the latest phase of the rally
have been precisions, electrical equipment and transportation
equipment, all linked to external demand and the yen. While
fundamentals are being supported by recovering capital expenditures,
the digital consumer electronics boom and growing overseas market
share, these sectors will continue to be hobbled for the foreseeable
future by the renewed strength in the yen and a consolidating US
market. These are the sectors that should find it most difficult to
de-link from a US equity market correction. Additionally, the Topix
Core 30, consisting of Japan's blue chips, has also under-performed
due to incremental unloading of stock by domestic financial
institutions attempting to get holdings of equities to below their
stated capital before the FSA-mandated deadline.
In addition, China-related plays such as chemicals, steel and shipping
-- all early leaders of the Japan rally -- are being hobbled with
concerns of a possible change in China's foreign-exchange policy and
comments by Chinese leaders that they would like to slow China's
growth to a more sustainable level. The stocks of companies like
Nippon Steel (5401) and JFE Holdings (5411) have failed to renew
January 2004 highs due to evidence that rapidly rising raw material
and shipping costs will noticeably crimp earnings.
As mentioned in last week's newsletter, we expect that domestic
institutional investors will begin the new fiscal year in April with
higher equity allocations. This is despite the fact that a large
portion of welfare pension funds being returned by individual
corporate pension funds to the government may not find their way back
into the stock market as Government Pension Investment Funds during
this timeframe. This is because pension-fund performance over the last
quarter has improved markedly.
-- Darrel Whitten
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