MW-52 -- Bracing for a Monetary Policy Shift

J@pan Inc Magazine Presents:
Weekly Financial Commentary from Tokyo

Issue No. 52
Tuesday, November 11, 2003

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++ Viewpoint: Bracing for a Monetary Policy Shift
The Bottom Line: The macroeconomic fundamentals continue to improve.
o The good news on job growth in the US is further evidence that
the US recovery is deepening. In Japan, while third quarter
GDP is expected to experience a noticeable slowing, there has
been a substantial recovery in business confidence and
evidence that consumer confidence should also rise in the
final months of calendar 2003.

o There is however a concern that global equity markets will
experience an interim correction as central banks shift gears
from historically unprecedented easy-money policies to more
"normal" monetary policies, as tighter money could remove a
lot of the excess liquidity currently driving stock markets.
But both the US Federal Reserve and the Bank of Japan have
gone to great pains to signal to markets that they would be
more likely to err on the side of "too easy, too long."

Bottom-Up: Investors adjust to post-monetary policy shift scenarios.
o The irony of the recent slew of excellent data points on the
US economy is that the US market has hardly reacted. Indeed,
it appears to have had a better impact on the market
psychology of overseas markets than on the US. The US market
has been trying to discount just such a scenario over the past
six months, and investors are well aware that too strong a US
recovery would only hasten the day when the Fed must move to

o The Japanese market, supported by the good news from the US,
has also been trying to discount the implications of a
significantly stronger yen, the prospect of much higher
interest rates, and a potential future shift in monetary
policy, even as bullish foreign and individual investors bid
the market higher.

o Ironically, the greater short-term risk for Japan may not be a
strong yen or higher interest rates, but merely that the
relative attractiveness of Japanese equities vis-・vis their
global peers wanes. The case in point is 7.2 percent GDP
growth in the third quarter in the US versus 1.5 percent
expected GDP growth in Japan for the same period. This is
particularly relevant because of the role foreign investors
have played in the rally to date and the psychological impact
their buying has had on domestic individual investors.

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++ Viewpoint: Bracing for a Monetary Policy Shift

The recent data on the US jobless situation clearly demonstrates
that the recovery in the US economy is deepening. The good news
on jobs follows a third-quarter US GDP that grew at a 7.2-percent
annual clip, well above the 6 percent economists expected and
the strongest quarter in 19 years. Also, the purchasing managers'
index for October was strong, hitting 57 rather than the 55.9 that was
expected, indicating a continued revival in manufacturing activity.
In addition, the third-quarter GDP contained a very encouraging
increase in IT capital expenditures.

Yet the US stock market has all but ignored the good news. One
reason is that the stock market has been trying to discount what
has been a slow recovery for some time now. Stock prices usually
discount such economic news three to six months in advance. The other
factor is that (as pointed out on October 27 by Money Watch) investors
are starting to get worried that the excess liquidity provided by the
Fed to date will go away. If the economy is really recovering as
smartly as it seems to be, the Federal Reserve may have to shift
monetary policy gears and raise rates a whole lot sooner than it's
letting on.

Investors in the US market are trying to figure out how much rope the
Fed will give the economy to recover before it begins to tighten
monetary policy and inevitably bring on an interim market correction
as the equity rally shifts gears from being driven by excess liquidity
to earnings growth. That's why stock markets traditionally perform the
best in the early stages of an economic recovery.

Japan's economic growth probably slowed to an annualized rate of 1.5
percent in the third quarter, but there has been a substantial
improvement in business sentiment. A stronger stock market, evidence
of economic recovery and reduced financial-sector and
corporate-bankruptcy risk have all contributed to the improvement
in sentiment.

In addition, consumer sentiment should continue to improve. While
overall household spending (consumption) fell 1.8 percent in real
terms in September from a 1.0-percent rise in August, employees at
Japanese private-sector corporations are likely to see their
winter bonuses rise from year-earlier levels for the first time in
seven years on the back of a recovery in corporate earnings.
Consequently, for those still employed and working at companies
that pay bonuses, the outlook is not so bad.

These sentiment indicators are important in that they are further
evidence Japan may be on track for a genuine economic recovery.

Thus the greater short-term risk for Japanese equities may
not be a strong yen, higher interest rates or a faltering
economic recovery, but merely the fact that the relative
attractiveness of Japanese equities vis-・vis their global
peers wanes. The US posted 7.2 percent third-quarter GDP growth, while
Japan expects 1.5-percent growth for the same period.

This is particularly relevant because of the role foreign investors
have played in the rally to date and the psychological impact their
buying has had on domestic individual investors.

Foreign net purchases of Japanese equities have slowed
significantly with the onset of October, while the steady stream
of net selling from domestic institutions continues, leaving the
market more susceptible to profit-taking. It can no longer be argued
that Japan had the fastest growing economy in the OECD and relatively
high profit growth.

If the flow of foreign investor funds remains slow or, as it did
during the third week of October, turns to net selling, this will
not only remove one strong source of buying support for the
Japanese market, but will also negatively affect the sentiment of
individual investors, leaving Japan's stock market at the mercy of
the steady stream of net selling from domestic institutions.

In this regard, it would not be a bad idea to have some exposure
to the pharmaceuticals, which have woefully lagged behind the rally
this year, but which always show up well on value screens.

Moreover, Money Watch believes that consumer discretionary stocks
(autos, consumer electronics, TV stations, housing contractors and the
like) will survive an interim consolidation with their relative
performance intact.

Conversely, the subject of negative reappraisal is the financials.
Speculation about when the Fed or the Bank of Japan will be forced to
change monetary policy has not and will not go down well with the
financials in any market.

-- Darrel Whitten

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Written by Darrel Whitten

Edited by J@pan Inc staff (


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