MW-64 -- Defensives Take the Lead, and That's Not Good

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

Issue No. 64
Tuesday, February 17, 2004

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++ Viewpoint: Defensives Take the Lead, and That's Not Good

The Bottom Line:

o Most commentary about the Japanese government's futile attempt
to stem the yen's rise actually confuses the issue. The most
common explanations seen in the media and even given by some
analysts is that the yen is appreciating because of export
growth and foreign buying of Japanese equities. That is simply
not true.

The major reason for Japan's current account expansion in 2003
is a shrinkage of the deficit in services. Moreover, from an
overall balance of payment perspective (i.e., including the
capital account), the largest factor has been a substantial
increase in "other investments," which the Finance Ministry
says are the repatriation of loans from domestic financial
institutions to overseas borrowers and loans from overseas
into Japan. In addition, the foreign direct investment and
portfolio investment outflow from Japan essentially swallowed
the net buying by foreign investors.

o Thus the significant increase in Japan's overall balance of
payments in 2003 was due more to repatriation of funds
previously lent overseas than to any substantial increase in
Japan's trade balance. Indeed, Japan's trade surplus with the
US last year actually shrank by $4 billion.

o The Japan super-bulls that forecast 20-30 percent gains in the
Tokyo market must now be scratching their heads. The Topix has
failed several times to surpass the high seen in October.
Moreover, investors have turned noticeably defensive. Only 15
of the 33 Topix sectors have gained so far this year, while
all of the economically sensitive sectors -- particularly the
basic materials sectors -- look to be entrapped in an extended
correction phase.

o The market is now being led by nonbank financials, real
estate, pharmaceuticals and airlines, all laggards in the 2003
rally. In other words, "defensives" are currently holding up
Japan's market. If the Japanese market is merely going through
a seasonal "setsubun tenjyo" peak, these sectors are merely
something to invest in until the Japanese market rights

o But if the Tokyo market is to again show the kind of superior
performance it showed in 2003, investors will have to regain
confidence in the sustainability of the economic recovery and
gain confidence that the strong yen has peaked or will do so
soon. Perhaps the best indicator of renewed vigor in the
economy and in the stock market will be an eventual return to
economically sensitive sectors that have born the brunt of
profit-taking since the onset of 2004. If these sectors can
show that they are more than one-year "rebound" plays, Japan
may have indeed turned the big corner in its fight against the
Heisei Malaise and deflation. Right now, however, both
domestic and foreign investors seem to be saying, "Show me."

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++ Viewpoint: Defensives Take the Lead, and That's Not Good

The US dollar began the Asian trading day firmer after finance
officials from the world's top economies warned that "excess
volatility" in exchange rates could damage the world economy. But no
one seriously believed that the G-7's vaguely worded statement would
actually change the direction of currency trading. This is because
there was little evidence of a collective will to intervene to redress
the process whereby the US dollar continues to depreciate. While the
G-7 was in agreement that a rapid decline in the dollar after the
previous G-7 meeting in Dubai was undesirable, the fundamental views
on the appropriate levels of the respective currencies still differ

With the G-7 meeting out of the way, dollar-selling was expected to
resume on the view that the US current account deficit is
unsustainable and that Washington is content to see the greenback fall
to correct that imbalance in order to ensure economic growth and as
few complaints about currency rates from industry as possible ahead of
November's presidential elections. The US still finds a gradual fall
in the dollar desirable as long as it does not negatively impact the
Federal Reserve's efforts to keep US interest rates in check. Recent
testimony in Congress by Fed chairman Alan Greenspan reveals that the
Fed finds current US rate levels "appropriate" and that the US
dollar's two-year fall has caused no "material effects." In addition,
the Fed, while recognizing that the strength of the US economy has
been a surprise, continues to assure the markets that it is in no
hurry to shift gears on monetary policy.

The Europeans, however, think that the dollar's fall has gone too far,
especially as it seems ready to test the $1.30-to-the-euro level
again. The EU's resistance to further strength in the euro rate versus
the dollar is likely to stiffen. The euro fell slightly against the
dollar on Monday after a published report said EU finance ministers
will discuss "all possible ways" to curb euro gains, raising the
prospect of possible dollar buying.

Japan, on the other hand, is prepared to do whatever is necessary in
terms of intervention to brake the yen's appreciation against the
dollar. It spent over 20 trillion yen last year and over 7 trillion
yen in January in support of the dollar. Moreover, Japan has budgeted
140 trillion yen in 2004 for further intervention, and the Finance
Ministry has temporarily sold 10 trillion yen of US treasuries to the
Bank of Japan to use as intervention funds until the fiscal 2004
budget is passed.

The positioning by the EU and Japan is a given to currency traders. So
far there have been no surprises. The newest development involves
China, who has been the focus of criticism by the G-7 for continuing
to peg the yuan to the US dollar. Beijing denied a weekend report in
the China Business Post that Beijing planned to let the yuan
appreciate by 5 percent in March and by 10 percent by next year.
However, the China Securities Journal also stated that allowing the
yuan to appreciate would help ease trade friction. It pointed out that
China has cut tax rebates for exporters this year, which will help
ease the pressure on the currency. Ostensibly, even allowing the yuan
to appreciate by 10 percent would not spark renewed deflation in

People's Bank of China governor Zhou Xiaochuan reportedly has talked
of a review of the dollar peg. Relaxation of foreign-exchange
restrictions by individuals and companies is also reportedly being
considered. The People's Bank has said for several months that it
plans to "perfect its exchange rate mechanism" and "keep the (yuan)
basically stable at an adaptive and equilibrium level." China has
agreed to receive a delegation of US Treasury officials within weeks
to discuss how Beijing might inject flexibility into its rigid
exchange-rate system. The meeting comes as speculation over the future
of the yuan intensifies.

If the yen and other Asian currencies including the yuan were allowed
to appreciate, it would remove a significant amount of pressure on the
euro, which could actually depreciate against the dollar by up to 10
percent. Conversely, Asia's foreign-exchange reserves have been
soaring as the US dollar declines because the favored method of
holding dollar balances acquired from interventions has been US
treasuries. Forex reserves in the Asian nations have soared anywhere
from 30 to 43 percent over the past year and are estimated to account
for over half of global forex reserves. In addition, the Asian
nations' holdings of marketable US treasuries account for 24 percent
of the total outstanding. The Asian nations accounted for no less than
65 percent of the net buying of US treasury bills and notes as well as
agency bonds during the first 11 months of 2003.

Japan's economy minister said last week that he was hopeful China
might be willing to loosen its foreign-exchange controls -- a move
that would allow its currency to rise against the dollar. Japan has
long argued that an artificially weak exchange rate gives Chinese
exporters an unfair edge over their Japanese competitors and
exacerbates deflation in Japan through imports of cheap Chinese goods.
Robust exports have been a major engine of China's surging economy,
which expanded 9.9 percent in the fourth quarter of 2003, raising
concerns that the economy is overheating.

China's M2 money supply (M1 plus time deposits of commercial banks; M1
is money in circulation plus demand deposits) was surging 18 percent
year on year in January, and even the People's Bank of China is
apparently worried that rapid monetary growth is causing bubbles in
real estate, auto loans and investment in basic materials. In
supporting the yuan-dollar peg, the People's Bank buys up all foreign
exchange and issues yuan in return. The liquidity created is helping
to fuel excess liquidity. To address those concerns, the People's Bank
said earlier that it would aim for money-supply growth of about 17
percent in 2004, slightly slower than 2003. It also pledged to cut
yuan-denominated loans by 13 percent to for "more sustainable"
economic growth.

The exchange rate of one country's currency against others, like any
other price, is determined by supply and demand. Sources of supply and
demand are basically fourfold:

1. Trade flows
2. Long-term capital flows; direct & portfolio investments
3. Speculative flows
4. Official intervention by monetary authorities

The problem is that most explanations of why the yen has continued to
appreciate despite massive intervention by the Finance Ministry and
the central bank only muddle the picture of what was actually

As there currently is sustained and large pressure for the yen to
appreciate, there is basically more demand for yen than there is
supply. But where this demand is actually coming from is a source of
confusion in most descriptions of why the yen is strong. In 2003,
Japan's current account balance rose by 11.6 percent from the previous
year, a more modest increase than the 32.7-percent increase in 2002.
Moreover, the trade balance increased a modest 4.4 percent and was
overshadowed by a noticeable shrinkage in the deficit on the services
account. As the income account was largely unchanged from the previous
year, this shrinkage of the deficit on the services account was a
major factor boosting the reported value of Japan's current balance of
payments in 2003.

Often, upward pressure on the yen is attributed to growth in exports
and fund inflows from net purchases of marketable securities by
foreign investors. This is simply not true. Japan's imports actually
grew faster than exports in 2003, at 5.1 percent versus 4.9 percent
year on year. Both exports *and* imports hit new historical highs
during the year. As for services, Japan became a net exporter of
patents in 2003 for the first time, helping to reduce the services
deficits. As for foreign buying of Japanese equities, net foreign
buying of 9.9 trillion yen in Japanese equities was dwarfed by a net
outflow of portfolio investment funds equaling 11.5 trillion yen. In
addition, there was a net outflow of foreign direct investment of 2.6
trillion yen.

Indeed, from an overall balance of payments perspective, *none* of
these factors had the largest impact, especially with regards to trade
with the US. While the US had a record trade deficit of $489.4 billion
in 2003, the deficit with Japan actually shrank by $4 billion to $66
billion, while the US trade deficit with China hit a new high of $124

The largest impact came from a net inflow of 22.0 trillion yen in
funds from "other investments," which resulted in a massive expansion
in Japan's overall balance-of-payments surplus from 5.7 trillion yen
in 2002 to 23.9 trillion yen. According to the Finance Ministry, these
inflows were basically repatriation of loans extended by Japanese
financial institutions as well as an increase in loans from overseas
into Japan. These loan repayments ostensibly were related to Japanese
banks' efforts to clean up their balance sheets. Since these fund-
flows have no direct connection to Japan's trade in goods and services
but do have a large impact on the overall demand for the yen, it now
becomes easier to understand why Japan intervened so heavily in the
currency markets in 2003: It was aware of these repatriations and the
significant impact it would have on demand for yen and thus the
yen-dollar exchange rate.

Consequently, all conjecture that Japan's yen has to appreciate more
to account for the balance-of-payments surplus with the US is woefully

Money Watch nevertheless believes that the yen's strength against the
dollar has yet to peak and will sometime in 2004 seriously challenge
and possibly surpass 100 yen to the dollar unless:

1. There is more visible evidence that the dollar's
depreciation is beginning to hit the US's record balance-of-
payments deficits.

2. The Fed finally begins to shift gears on US monetary policy
by nudging up US interest rates.

Any movement by China to make its currency-peg regime more flexible
and thereby engineer a 5-10-percent depreciation in the yuan could
have a more significant impact on the euro and other Asian currencies
than on the yen, given the real reason for Japan's balance-of-payments

From the onset of 2004, the Japanese stock market has begun to lag
further behind its global peers. For example, the S&P Global 1,200
index has gained 4.3 percent and the S&P 500 has gained 3.6 percent so
far this year, but the S&P Japan 500 has slid 1.0 percent.

Sector divergences are developing. In energy, for example, the S&P 500
energy sector is up 4.2 percent year to date, while Global 1200 energy
is basically flat. Japan's energy sector, on the other hand, has
fallen 3.7 percent. Telecom services offer another noticeable
divergence. Globally, telecom is up nearly 6 percent this year, and
the US sector has tacked on nearly 7 percent. But Japan's sector has
tanked by more than 9 percent. Even information technology, which has
held up well globally, has slipped nearly 2 percent in Japan. Japan is
also at a disadvantage in global portfolios when the consumer-
discretionary sector (consumer electronics and automobiles) begins to
under-perform, as it has since the onset of 2004. In the S&P indexes,
the weight of this sector is two times that of the S&P 500 and the S&P
Global 1200. The Japan 500 index also has a noticeably heavier
weighting in industrials, another under-performing sector of late.

Earnings numbers for Japan's global blue chips are not particularly
bad. Indeed, with some exceptions, these companies are expected to
report some very good numbers in the fiscal year ending March 2004.
But investors have begun to shy away from economically sensitive
stocks and increase their exposure to more defensive sectors. This
would appear to indicate that an excessive amount of expectation is
already in the stock prices of these sectors.

Moreover, investors see the Japanese markets inability to renew
October highs and are beginning to suspect that Japan's economic
recovery may start peaking out in the first half of 2004. The yen's
continued strength only adds to such concerns. For domestic investors,
the fact that foreign investors turned net sellers in the first week
of February is another cause for concern.

What investors appear to be trying to discount is a replay of the
1999-2000 market. By the end of 1999, the top 10 gaining sectors were
all economically sensitive sectors, but as 2000 rolled around,
virtually all of these sectors began to under-perform and were
replaced by defensive sectors. These sectors remained in the market
lead until the peak in April. The economy did not peak until fall

From the onset of 2004, virtually all of the basic materials sectors
have been a significant drag on the Topix. Year to date, the mining,
pulp/paper, nonferrous, iron/steel, textiles/apparel and oil/coal
sectors have all corrected between 1.2 and 6.8 percent. Leading the
sell-off are the steel and shipping sectors, two of the best
performers in 2003. Looking at the technical picture of these sectors,
it is apparent that all have some more consolidating to do, even if
they have not yet entered a bear market. All have either broken down
through their 26-week moving averages or are on the verge of such a
breakdown. Indeed, only 15 of the 33 Topix sectors are showing a gain
for the year to date.

Conversely, nonbank financials, real estate, pharmaceuticals and
airlines have hit new post-October 2003 highs, while the
insurance sector is seeing support at its 13-week moving average.
In other words, "defensive" and obvious late-coming sectors are
now holding up the Japanese market. Year to date, other finance
has surged 24.1 percent; real estate, 15.8 percent; airlines, 13.9
percent; and pharmaceuticals, 4.5 percent. If the Japanese market is
merely going through a seasonal "setsubun tenjyo" peak, these sectors
are just places to deposit money until the Japanese market rights

But if the Tokyo market is to again show the kind of superior
performance it showed in 2003, investors will have to regain
confidence in the sustainability of the economic recovery. They will
also have to be confident that the strong yen has peaked or will peak

Perhaps the best indicator of renewed vigor in the economy and the
stock market will be a return to the economically sensitive sectors
that have born the brunt of profit-taking since the onset of 2004. If
these sectors can show that they are more than one-year rebound plays,
Japan may have indeed turned the big corner in its fight against the
Heisei Malaise and deflation. Right now, however, both domestic and
foreign investors seem to be saying, "Show me."

-- Darrel Whitten

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