Investor insight: Signs of a Real Recovery?

Back to Contents of Issue: April 2004

Our money master provides an overview of the likelihoods.

by Darrel Whitten

In 2003, Japan managed to recover and surprise critics despite continued deflation. This has led some to insist that there was no liquidity trap in Japan, and that despite the zero-interest-rate policy, monetary policy made an important contribution to the expansion.

Monetary policy was able to provide stimulus despite financial fragility in the banking system, which was unable to fulfill its traditional banking role of being a money multiplier. While the divergence between the monetary base and the money stock continued to expand, the Bank of Japan's reluctant purchases of Japanese government bonds, "unconventional" assets like asset-backed securities and equities from the banks helped to change the composition of the monetary base.

With the unemployment rate falling and construction orders rising, business confidence should continue to improve in 2004. Accelerating global trade growth should continue to support demand for Japanese exports, led by renewed economic growth in China and the US. This, along with improving corporate profitability (the strong yen notwithstanding), should continue to support Japan's economy.

Bank of Japan (BOJ) Governor Toshihiko Fukui apparently believes quantitative easing worked to stop Japan's deflationary downturn, and therefore it must have the power to give an additional push to Japan's economic recovery and eradicate deflation. Domestic think tanks seem to agree. They foresee impressive growth in Japan's third-quarter GDP of 4.9 percent annualized, or higher than that of the US. This would represent the fastest growth in Japan since January 2002.

Growing belief in reflation
The pall that hung over Japan's equity market in 2002 suddenly lifted in March 2003, when the government decided to appoint Fukui, chairman of the Fujitsu Research Institute and a former deputy governor of the BOJ, to serve as the next BOJ governor, replacing outgoing governor Masaru Hayami, whose term was ending on March 19. Given Japan's deflation problems, the Japanese government, foreign governments and investors had become increasingly frustrated with Hayami, whose caution on the use of unconventional monetary policy was always predicated with demands to the government to implement more effective reforms first.

BOJ observers both within and without Japan believed that more aggressive, unconventional reflationary measures were the only way for Japan to kick-start its economy. With unsterilized intervention, for example, the money supply would grow more rapidly, ostensibly stimulate economic activity and act as either a substitute or a complement for fiscal policy. In addition, it would theoretically put downward pressure on the yen -- the object of the BOJ's forex interventions in the first place. Finally, if done in sufficient quantity, it would theoretically raise inflationary expectations.

But the BOJ under Hayami had consistently resisted this pressure, believing there was already excess liquidity available to financial institutions, which could not or would not use the excess funds they already had (as huge current account balances at the BOJ). More-over, Hayami believed that government needed to achieve more in terms of bank reforms before the central bank would embark on "risky and untried" monetary policy options.

Since Japanese short-term interest rates under the zero-interest-rate policy effectively fell to zero, the BOJ has been conducting experimental monetary policy. When Fukui assumed his post, the BOJ immediately held a rare emergency meeting to discuss nervous financial markets in the wake of the beginning of the Iraqi conflict. The BOJ decided to expand its ability to buy shares held by banks and started discussions about purchasing asset-backed securities to stimulate growth in a market for the securi- tization of accounts receivable from small businesses.

When the BOJ first adopted "quantitative easing" in 2001, its focus for monetary policy shifted from interest rate targets to current account balances and other liquidity targets. By January 2003, current balances at the BOJ had soared from JPY5 trillion to JPY6 trillion to JPY20 trillion, but with no favorable impact on the economy or on the stock market. In March 2003, the BOJ again raised its target for excess liquidity from JPY22 trillion to JPY27 trillion to JPY30 trillion to JPY35 trillion.

Foreign investors, encouraged by the appointment of a new, more flexible BOJ governor and a very "soft-landing" type of bailout for Resona Bank in May, began to suspect that the BOJ's increasingly large and overt interventions in the currency markets were also not being sterilized (i.e., prevented from influencing the domestic monetary base through further increases in current account balances). This view was not particularly discouraged by the central bank. Current account balances, after all, continued to swell as the BOJ continued to raise the ceiling.

But the real issue is why the expansion from JPY5 trillion in current account balances to JPY20 trillion failed to produce the same dramatically favorable impact on stock prices as the expansion from JPY20 trillion to more than JPY30 trillion did in 2003.

The dramatic change in direction appears primarily attributable to a shift in investor (mainly foreign investor) perceptions regarding the BOJ's actions. The massive net buying of Japanese equities in 2003 was instigated by the conjecture that a "new, more flexible" BOJ would initiate more aggressive reflation measures.

Indeed, the sharp back-up in Japanese government bond (JGB) rates in the second quarter of 2003 was evidence of a shift in future expectations for inflation. JGB yields had been pushed down below 0.5 percent, implying that investors had all but given up on Japan being able to reflate its economy and eradicate deflation.

But as the economy began to recover and bond yields soared, speculation began to circulate about the possible exit strategies the BOJ might take when its stated goal of eradicating deflation was achieved and what benchmarks the BOJ would use in declaring victory over deflation. "The Bank of Japan aims at putting Japan's economy back on a sustainable growth path by firmly maintaining the quantitative easing policy based on clear and concrete commitment with reference to the consumer price index," Fukui said.

A strong IT recovery?
The big picture remains positive for the Japanese market. The Topix has seen a "golden cross" (a bullish sign where a shorter moving average crosses upward through a longer moving average) between its 40-week and 80-week moving averages. Moreover, commodity prices have finally pulled out of a 20-year bear market that began in late 1980, and have entered a secular recovery. The next to follow is bond yields, and even though central banks, led by the Fed, will attempt to delay the shifting of gears in monetary policy as long as possible, interest rates will inevitably rise as the bull market in commodity prices continues, and the global economic recovery broadens.

The Fed's reluctance to change course on rates reflects the continued risk for the global equity markets of a recurrence of 1987, where a sharp rise in commodity prices caused bond yields to soar amidst a falling dollar, leading to a crash in the stock market. So far, the rise in global commodity prices has been prevented from pushing up bond yields by extraordinarily loose monetary policy, aided by massive purchases of US debt by foreign governments such as Japan. It is thus key that the major central banks manage to make this transition from "deflation" to "inflation" as smoothly as possible, without a crash in the US dollar and without a surge in US bond yields to two-digit levels.

For sector allocations, the fact that commodities, stocks and bonds were rising last year indicates that the global economy, led by the US, was already in the early stages of recovery. In their latest communique, the G-7 acknowledged that the global economy is in recovery.

This recovery was already being signaled by the strong performance of the industrials, basic industry and energy sectors in 2003. Indeed, according to the US Conference Board's latest forecast, the US and major world economies are on the threshold of a genuine economic boom and will likely record their best years since 84. This recovery, however, has so far been a "jobless recovery," with consumer and business confidence lagging behind the early stages of the recovery. However, as the Conference Board points out, "given the acceleration in corporate profits and the decline in the US unemployment rate -- headed back to 5 percent or lower -- business investment in manufacturing and technology could actually exceed the gains of the early 90s." In addition, consumer confidence is now rising -- further verification that the recovery has taken root. The Conference Board's consumer confidence index rose briskly in January, with the expectations index and the present situation index showing good gains. Even with a February dip, consumer confidence in the US is now at its highest level since July 2002. Thus, if the US can manage to avoid a dollar rout and keep interest rates under control, US and global equities have very solid fundamental support for a continued rally.

Typically, the industrial, energy and basic materials sectors tend to outperform in the early stages of the economic recovery, and that is indeed what occurred in 2003. These sectors peaked with the onset of 2004. The weight of the energy sector in the S&P 500 is now 3 percent, which is higher than it was in January 2000, while the basic materials sector has regained 90 percent of its prior weighting. The "jobless recovery" in the US did little harm to housing demand, which was actually soaring, providing a major underpinning for a US economy on the mend. As interest rates inevitably rise, however, it will stunt the housing expansion as well as other interest-rate-sensitive sectors, including consumer durables such as automobiles. In addition, consumer cyclical stocks in the US already turned sharply higher in March 2003 and as a group have surged 47 percent since.

Actually, the two major sectors that remain significantly lower in weight to the S&P 500 today than in January 2000 are technology and telecommunications services. The weight of the tech sector in the S&P 500 plunged from 28.2 percent in January 2000 to 15.7 percent by October 2002, and since has recovered to 18.5 percent, a full 34 percent below peak weightings. The telecom services sector fell from 7.8 to 4.1 percent and continued falling while the rest of the market was rallying, hitting a low of 3.3 percent in January 2004.

With rosy forecasts for both global economic growth and trade, as well as rebounding consumer and business confidence, capital expenditures are again being ramped up and could well surprise on the upside. The stage is being set for a full-fledged recovery in IT and telecom services in 2004.

Topix is looking top heavy
Despite all this bullishness, the Topix has tried to breach 1,100 twice and failed. In 2003, it rallied to just above 1,100 but was unable to convincingly breach this level. Another attempt in December to January ended with a lower high, and the Topix has now broken under its 13-week moving average and is bouncing on its 26-week moving average. If business sentiment in Japan is improving, foreign investors are still bullish and GDP and corporate profit numbers for the third and fourth quarters are expected to be good, why is the Topix so top-heavy?

One explanation could be that the supply-demand situation is still delicate and could deteriorate further. The yen's strength continues to weigh on investor sentiment. Yet as the yen continues to push toward new highs despite massive intervention, Fukui declared in December that the yen's rise might not be that damaging to the profitability of Japanese companies. Third-quarter numbers at the major companies -- including Matsushita and Toyota -- showed that companies that continued reforms and kept a lid on costs were able to report robust increases in profits despite the yen's strength.      @

Note: The function "email this page" is currently not supported for this page.