Investor Insight: The Next <I>Izanagi Keiki</I>?

Back to Contents of Issue: August 2004

Japan's economic recovery looks built to last.

by By Darrel Whitten

The current working assumption is that Japan's economy is about to peak, and that a cyclical downturn will begin forming in 2005--even before the Bank of Japan (BOJ) has become confident enough to abandon the zero interest rate policy it has had in place since the third quarter of 2000.

Yet this recovery is different than its Heisei Malaise peers in that it was grass-roots, not fiscal stimulus-driven. Yes, if this is an average recovery for Japan, we are at the 29th month in this expansion, versus a median expansion of 28 months in the postwar period. However, during the postwar period, Japan has had two expansions of record proportions--the Izanagi Keiki between October 1965 and July 1970, and the Bubble Keiki between November 1986 and February 1991.These two expansions lasted 57 months and 51 months respectively.

Moreover, if we are correct in our conjecture that the current recovery potentially resembles the Izanagi Keiki--in that it is the beginning of a major renaissance for Japan (as the US saw from the mid 80s)--this recovery is but half-way through its cycle. Growing momentum in the secular part of the recovery could well support an extended cyclical recovery.

An extended recovery would have very bullish medium-term implications for Japan's stock market, even though the market has already gained some 60 percent to its highs back in April. During the Izanagi Keiki, the Nikkei 225 traded at a PER between 27.6x and 9.1x earnings, while the PBR trended between 2.9x and 1.0x--implying an ROE of between 10.5 percent and 11.1 percent.

By comparison, one has to go back nearly forty years to find the Nikkei 225 trading at its current PER on prospective earnings of 17.5x. During the Izanagi Keiki, the Nikkei 225 rose some 2.48-fold in discounting the extended recovery. If this recovery is, because of an ostensible renaissance in Japan's economy, of similar proportions, the Nikkei 225 could well be some 2.5x higher by the time the recovery eventually peaks--at over 18,000.

US investors still on inflation watch
In the US, there's good economic news and good corporate news, yet concerns about inflation forcing the FED to raise rates persist. All three major US stock markets finished last week with an uptick, ostensibly keeping alive a rally that began a month ago, which has some calling this a summer rally.

Consensus estimates for major US economic data back in June included a 1 percent rise for retail sales in May and a 0.8 percent gain in industrial production, with the month's plant capacity usage running at 77.5 percent. Data on housing starts was expected to show homebuilders broke ground at a seasonally adjusted annual rate of 1.95 million new units, while new building permits are expected to come in at an annual pace of 1.97 million.

Ostensibly, the higher the 10-year treasury yield goes, the less attractive high price-to-earnings multiples look. One factor behind concerns about increasing inflation had been soaring gasoline prices. In June the US AAA reported the average retail price for a gallon of gas fell to $1.994, but this was still 50 cents higher year-on-year. Crude oil prices, which had been hovering above $40 a barrel in late spring, closed at $38.45 a barrel in late June.

Helping to alleviate oil price concerns was OPEC, which announced earlier this month that it would raise its official daily production quota by more than 2 million barrels to 26 million barrels and, if necessary, by an additional 500,000 barrels on at the start of August. Aided by boosts in gasoline production and the dip in oil prices, the US saw its first nationwide drop in gas prices during this year, giving further support to the idea of a summer rally instead of a "sell in May and go away" scenario.

Stocks discount economic growth
Shares of US raw material suppliers, banks and technology companies, all of which are hurt the most by the conjecture of slowing economic growth, have been under the greatest pressure. Investment scenarios have apparently gone beyond mere rate hikes to the potential impact of these rate hikes--i.e., more aggressive FED tightening to a degree that would slow the US economy.

Each meeting of the FED will raise the same fearful questions: Will they raise rates? And what if they get behind the inflation curve and have to rush to catch up? Indeed, the consensus is leaning in this direction, with the US central bank expected to double its key rate to 2 percent by the end of the year, according to a recent Bloomberg survey.

A mini "perfect storm?"
June 30 is the day the US-led coalition hands over Iraqi sovereignty to its people. Much like the Fed meeting has sparked concern about higher rates, the Iraqi handoff has heightened expectations for terrorist attacks. Having both a negative surprise by the FED and a ramp-up in the level of terrorism with the handover of Iraq would be the equivalent of a mini "perfect storm" for the US stock market, possibly destroying the fragile summer rally.

On average, S&P 500 companies raised second quarter profits by 19.9 percent, according to analysts polled by Thomson Financial. Better than expected results would mark the third straight period of at least 20 percent growth. But this already appears to be discounted, and analysts predict profit growth will slow to 13.8 percent in the third quarter and 15.1 percent in the fourth. Thus investor eyes are on the FED and what more aggressive action by the central bank will do to GDP growth and corporate profits. The operating assumption at this point apparently is that neither would be bullish for the stock market.

However, as we previously pointed out, it is our suspicion that this is part of the "wall of worry" that sustainable bull markets climb. If a mini "perfect storm" is avoided, a continuation of the summer rally is assured, with stocks rising in July as well. If both events prove to be benign, it will not only be a boost to stocks but also would noticeably boost President Bush's reelection bid, a result that is apparently favored by Wall Street.

In addition, there is good news in terms of corporate America's ability to absorb rising costs given inflation. US Government productivity statistics, revised in June, showed productivity increasing 5.5 percent over the previous 12 months, matching the fastest productivity gains in 31 years. And USA Today's annual exclusive look at the productivity gains made by the nation's largest 100 companies shows that the country is on a multi-year roll not seen since just after World War II.

Productivity gains in 2002 were largely due to slashing costs as companies worried about shrinking profits at a time when they could not raise prices. The continued rise in productivity, arm-in-arm with the resurgent economy, has been a pleasant surprise. The benefits of productivity improvements extend far beyond corporate boundaries, by helping hold down inflation and keeping interest rates in check.

US economy still the world's driver
Just about any consensus estimate of the developed world's economies has the US firmly in the driver's seat, and not expected to relinquish its role as the developed world's economic driver for the foreseeable future.

Continued high growth in the US economy however means a relative shrinkage of liquidity, with broad money supply growing at about the same rate as the economy. The same is true for Japan, where expected economic growth is over two times recent M2 money supply. Conversely, excess liquidity has yet to kick-start Euro-land's economic engine, where expected GDP growth is an anemic 1.7 percent versus M2 money supply growth of 5.6 percent. Thus, while the US and increasingly Japan are in the midst of a shift from an excess liquidity-driven financial markets, Euro-land still has excess liquidity.

Wishful thinking on rates in Japan?
Japan's benchmark JGB yields reflect what is increasingly obvious: Japan's "Heisei Deflation" is ending, and with it, market expectations that deflation would continue unabated for the next decade--as was apparently being discounted in JGB yields when they hit a new historical low of 0.43 percent in June, 2003.

Economists insist that the upper limit of this rate rise, which has tacked on 142.5 basis points since previous historical lows to a recent rebound peak of 1.855 percent, or nearly back to the 1.99 percent level that was prevalent when the BOJ first initiated their zero interest rate policy (ZIRP) in August 2000.

Since the cyclical recovery in Japan's economy is already nearing a peak, and will begin to decelerate from 2005, it would ostensibly be increasingly difficult for the BOJ to end its ZIRP policy. Their stated prerequisites for dismantling ZIRP include having a CPI that is consistently trending above zero percent. The majority of the BOJ's monetary policy board is confident this trend is sustainable, after an overall evauation of economy and prices.

Given the rise in global oil prices that is beginning to filter through the Japanese economy, Japan's CPI could turn positive in the July-September quarter, Many economists are hoping that the BOJ will remain cautious enough on the economic outlook (given the prospect of an imminent peaking-out of the cycle) to forego abandoning the ZIRP.

An above-average recovery?
The conjecture that the current short-term expansionary cycle in Japan's economy is partially related to concerns about a slowing in the US and China (or worse, a hard landing for China) and to historical data on Japan's postwar expansions. If the conjecture is that the current economic expansion in Japan is of average length, the current expansion is indeed about to peak. If this is the case, the stock market's peak in terms of the Nikkei 225 at 12,163 on April 26, 2004 will indeed have been the peak of this cycle.

On the other hand, the median expansionary period during the post-bubble years in Japan's economy has been more like 39 months, with the stock market "reading" this peak a median of six months in advance.

As we have pointed out on numerous occasions, there have been two major components of Japan's "Heisei Malaise": the cyclical component and the secular component. During the malaise period, each cyclical downtrend in the business cycle was exacerbated by a stronger, secular downtrend in the econonomy. Also, the earlier expansionary periods were artificially created through massive fiscal stimulus, and thus were not sustainable.

That is precisely what makes the current recovery different. Yes, the catalyst for the current recovery was exports and external demand. However, there has been no fiscal stimulus. Indeed, year-on-year declines in terms of the contribution from fiscal stimulus mean that the contribution from the private sector has actually been better than what the aggregate GDP number suggests.

What began as an externally driven recovery has continued to broaden and deepen into the domestic economy, reviving once moribund domestic consumption.

If our conjecture that the secular recovery will support and prolong the cyclical recovery is proved correct, we may as yet be only halfway through instead of near the end. Increases in personal consumption, a recovery in international competitiveness, noticeable improvement in the financial system and even hints of increased demand for loans (credit creation) are providing further evidence of sustainable improvement.

During the Izanagi Keiki, Japan's economy expanded for 57 continuous months between October 1965 and July 1970, and it expanded continuously for 51 months during the Bubble Keiki between November 1986 and February 1991. In terms of the economic environment, today's scenario looks far more like the Izanagi Keiki, where robust domestic demand was complemented by growing international competitiveness.

With rising competitiveness abroad and strong growth at home, heavily leveraged balance sheets and high interest rates were not a serious problem, as JGB rates ranged between 6 and 7 percent, while the stock market as measured by the Nikkei 225 rose 2.48x during the period and valuations were reasonable--with the market selling at a PER between 27.6x and 9.1x, a PBR of 2.9x to 1.0x and implying stated ROEs of between 10.5 and 11.1 percent, versus 8 and 9 percent at present.

Nikkei 225 at 18,000-plus?
If the secular recovery supports an historically long business cycle expansion, we could very well see stock prices rise the same degree they did during the Izanagi Keiki, similar to the US in the 80s. While interim corrections are inevitable, the market could end up being 2.5x higher at the end of this historically long expansion. This would indicate a Nikkei 225 level of 18,800--or some 2.5x higher than the 7,600 secular trough in 2003--in only the next couple of years. @

Darrel Whitten is owner of Whit Consulting, LLC, and is editor and publisher of A veteran investment analyst, he has been following Japan's financial markets for over 20 years. Please mail comments to:

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