Investor Insight: Terrorism, the US Correction and Japan

Back to Contents of Issue: May 2004

Our analyst tackles the terrorism tax and tips on Japan.

by Darrel Whitten

Since September 11, 2001, terrorism has become a fact of life. The ongoing and increasing risk of major acts of terrorism represents not only an immeasurable risk to the financial markets, but also acts as a tax on economies in the form of costs incurred 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, shouldered 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 S&P 500 is at 23.3 times earnings now, or above the post-1946 average of 16.1X . 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, which followed 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 Individual Investors.

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 to soar.

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 US job growth. If job growth were to actually accelerate to the levels ostensibly needed to ensure President Bush's reelection, 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.

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 stun 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 supported by three major developments.

Aggressive reflation efforts by the Bank of Japan (BOJ) have allowed current balances held at the bank to swell to over JPY30 trillion, while at the behest of the Finance Ministry, the BOJ has massively intervened (also in excess of JPY30 trillion) to cap the yen's rise. In addition, a consistently tough attitude by the Koizumi administration and the Financial Services Agency has kept up the pressure on the nation's banks to reduce nonperforming loans. At the same time. Koizumi and Co. remain ready to nationalize any institution that may present a threat to the stability of the financial system.

Finally, there has been a surge in grass-roots efforts by Japanese companies to restructure and reform their businesses to regain lost profitability and global competitiveness.

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. Even domestic knitwear textile producers are starting to make a comeback. Onward Kashiyama 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 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 JPY7,000 to JPY8,000.

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 drought 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.

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 reasonable valuations.

Prospects for the sector have recently brightened further with the announcement that the Mitsubishi Tokyo Financial Group, Japan's strongest banking group, will be taking a 1 -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, Promise and Sanyo Shinpan Finance 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 and solid leaders of the current Japan rally -- are being hobbled by concerns of a possible change in China's foreign-exchange policy and comments by Chinese leaders suggesting that they would like to slow China's growth to a more sustainable level. The stocks of companies like Nippon Steel and JFE Holdings have failed to renew Jan-uary 2004 highs owing to evidence that the rapidly rising costs of raw materials and shipping will noticeably crimp earnings.      @

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