MW-66 -- This Time May Be for Real, but 2005 Will Be Tricky

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

Issue No. 66
Tuesday, March 9, 2004

EDITOR'S NOTE: We were unable to post Money Watch last week, so this
week, we'll be sending two issues. Look for No. 67 later in the week.

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++ Viewpoint: This Time May Be for Real, but 2005 Will Be Tricky

The Bottom Line:

o World financial markets began discounting a deflationary
threat from the middle of 1997 as the Asian currency crisis
was evolving. The US Federal Reserve finally acknowledged this
threat in the spring of 2003, and most central bank monetary
policy since has been conducted with an eye toward avoiding
the deflation that has plagued Japan during the Heisei

o A falling currency is one significant cure for falling prices
because it is usually considered inflationary. While
maintaining the growing farce of a "strong dollar" stance, the
US Treasury and other government officials (in direct contrast
to Japan) have shown they are willing to let the dollar
depreciate so the US economy can be reflated.

o The global reflation story to date has been predicated on: a)
the Fed maintaining its extraordinary "deflation fighting"
policy stance; b) the continued gradual decline of the dollar;
and c) global central banks effectively "sterilizing" any
negative effect on US rates from the dollar's fall with their
purchases of US treasuries. But a widespread rally in
commodity prices (including gold, industrial metals and even
agricultural products) such as the one already seen has
historically meant an inevitable rise in bond yields to
reflect growing inflation expectations.

o For the central banks, that indeed was the object of the
exercise of their reflation efforts. The next stage of the
budding inflationary wave is the passing on of price rises in
primary basic material products to intermediary products. But
the rise in upstream basic material prices will not be seen in
downstream final products until a year or a year and a half
from now. This implies that 2005, not 2004, may be the
trickier period as regards a possible shift in monetary policy
by the US, followed by the BOJ. If the transition is done
badly, we could see a repeat of 1987, where commodity price
rises led to a sharp rise in bond yields that led to a sharp
sell-off in stock prices and a renewed plunge in the dollar.

o After having lagged behind global markets since October of
last year, the Japanese equity market has gotten its second
wind, aided in no small part by a "stealth rally" in the
retail sector, which has only recently begun to blatantly
out-perform the aggregate indexes, ostensibly on expectations
that the end of deflation is near. Cynics would say that the
move in retail is the last leg of the 2003 rally. But Money
Watch would like to think that this movement is merely another
indication of the emergence of a Japan renaissance and yet
another indication that Japan is turning the big corner on the
Heisei Malaise.

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++ Viewpoint: This Time May Be for Real, but 2005 Will Be Tricky

Intermarket trends since the Asian currency crisis in the middle of
1997 had been indicating a growing deflationary threat. Markets, in
discounting investor fears, greed and expectations, had already been
trading for several years based on the assumption that the deflation
threat was for real. It took more than five years after the 1997 Asian
crisis, the worst bear market since the deflationary 1930s, and
chronic deflation in Japan before the US Federal Reserve finally
expressed some concern about the threat from falling prices in the
spring of 2003. The US bond market's reaction was predictable. The
yield on the US 10-year Treasury Bond fell to the lowest level in 45
years. While the Fed was rapidly reaching the limits of how low it
could lower rates (as had already happened in Japan), there was
something it more than willing to do: Push the dollar lower. A falling
currency is one significant cure for falling prices because it is
usually considered inflationary. While maintaining the growing farce
of a "strong dollar" stance, the US Treasury and other government
officials began sending signals that they were willing to let the
dollar depreciate so the US economy could be reflated.

The first investment that traders went after was gold. Gold prices had
already bottomed in late 1999 and had broken out of a 20-year bear
market. The strong rally in commodity prices led by gold should have
put downward pressure on the bond market in 2002, but it did not, as
bond prices rallied along with commodity prices in 2002. Early in the
spring of 2002, industrial metals, interest rates and the stock market
were falling. The primary concern was deflation.

The close correlation that had developed between US bond yields and
Japan's Nikkei index is indicative of the drag that Japan's economic
malaise and deflation was having on US rates and global stock markets,
at least in terms of financial market perceptions. By the spring of
2003, however, industrial metals had become the strongest commodity
group as it exerted upward pressure on interest rates. Global
commodity prices, not just industrial metal prices, were clearly on
the rise. In early 2002, the Reuters CRB futures index confirmed a
previous secular low hit early in 1999 and had clearly begun to rise,
indicating the beginning of a new secular bull market for commodities.

Conversely, the 30-year bond price/S&P 500 ratio bottomed in early
2000 along with the cracking of the secular bull market in stocks.
Over the next three years, bonds were clearly the place to be, as the
bond price/S&P 500 ratio continued to rise. Later, this ratio showed a
double top, and given the substantial rise in commodity prices, the
time has come to abandon this trade. However, as of late 2003, the CRB
index/30-year bond price ratio had yet to show a major break to the
upside. What this indicates is that central bankers (particularly the
US), while pumping in as much liquidity and stimulus as possible to
reflate the global economy, have at the same time succeeded so far in
containing inflationary expectations as expressed in national consumer
price indexes and long-term bond yields. Thus the global reflation
story to date is based on the following premises:

1. The Fed continues to maintain its extraordinary "deflation
fighting" monetary stance and remains patient regarding any
emerging inflationary pressures in the US economy.

2. The US dollar continues to gradually decline, but not to
the point that it becomes a rout, thereby spooking global
financial market participants.

3. Global central banks (particularly Asian ones and
especially Japan) continue to effectively suppress any
pressure for US bond yields to rise with substantial net
purchases of US treasuries.

4. China has been both an engine for the recovery (especially
for Japan exports and global commodities) as well as a source
of the US trade imbalance because a recovering US economy is
drawing in imports while so far as yet failing to produce any
significant job growth.

Thus, the first move of the next secular inflation trend is in place:
a sustained appreciation in commodity prices. The biggest driver of
the almost across-the-board upswing of commodity prices has been an
explosion in demand in fast-growing China, which imported a record
91.1 million tons of crude oil last year, up 31.2 percent from the
previous year. China surpassed Japan in 2002 to become the
second-largest consumer of oil, following the US, and it is now
rapidly catching up with Japan in terms of oil imports as well, amid
soaring energy demand from both households and industries.

China's steel consumption has also been growing at a rapid annual
volume of 30 million tons since 2000 -- an amount roughly equal to the
total yearly output of Nippon Steel (5401). This is not only
tightening the global markets for iron ore and coal, but also pushing
up shipping fees.

With demand expected to start booming in places such as Southeast
Asia, India, Turkey, Brazil and East Europe, some analysts expect
commodity prices to remain on an upward trend indefinitely. There are
other factors contributing to the steep rises in commodity prices,
including more effective production adjustments by OPEC over the past
few years and more serious commitment by its members to maintain their
production quotas. The instability in the Middle East has remained a
geopolitical risk that is also being discounted in commodity prices.
Finally, dollar weakness is driving investors to seek hedges against
the ongoing depreciation of their dollar-denominated assets.

What is surprising given this rise in commodity prices is that global
inflation has remained tame. China is viewed as being a major factor
in both contributing to the climb in commodity prices and in keeping
inflation down. China is churning out industrial goods of all kinds,
from textiles to machinery to electronics, at very low cost thanks to
its cheap labor. Low-priced exports from China are curbing pickups in
the prices of finished products worldwide. Chinese producers are
managing to keep costs from rising despite higher commodity prices
through productivity gains from technological progress and the
economies of scale from expanded production. The shift of production
to China by many companies in major industrial countries has also
helped prevent higher material costs from translating into stiffer
price tags on sophisticated industrial products.

However, continued rises in commodity prices will eventually begin to
bite into corporate profits unless companies can pass these costs on
to consumers via higher prices. Encouraged by surging demand at home
and overseas, basic-material industries in Japan are going on the
offensive by asking their customers to accept price hikes.
Manufacturers of steel and chemical products and printing paper have
regained their negotiating edge with users following sweeping
industrial overhauls. Major steelmakers are making requests to user
firms, such as shipbuilders, to accept raised steel sheet prices for
the third time since 2002.

The market for primary industrial materials, such as steel and
plywood, is experiencing a surge in the price of upstream basic
materials, including iron ore and coal. The nearly 20 percent
increase in iron ore and coal prices for the major mining operators
threatens to reduce profits at the five Japanese blast-furnace
steelmakers by about 130 billion yen. Repercussions from primary-
material price hikes have already hit Japan, where the wholesaler
price of H-shaped steel beams, a typical construction material, has
jumped 16 percent in Tokyo and 22 percent in Osaka since the beginning
of this year. The surge in H-beam prices was sparked by an expected
20-30-percent jump by this spring from the beginning of the year in
prices of H-beam materials such as iron ore, coal and steel scrap.
Makers of shadow masks used to make cathode-ray tubes have started
curbing the volume of new orders because of the inability to fully
pass on higher materials costs to its own prices.

The price of nickel, one of the materials used to make shadow masks,
has rocketed 80 percent over the past year, but the company was able
to raise the prices of shadow masks only by 5-10 percent last year.
Domestic plywood makers are shifting to domestic logs, as prices of
New Zealand and Russian logs have soared 40 percent in the past year.
Japan log prices have so far been stable.

With naphtha prices surging due to growing demand in other Asian
countries, major petrochemical producers are set to raise the prices
of their products. The petrochemical firms have been operating their
facilities at full capacity thanks to increasing exports to China and
other Asian markets. Majors such as Mitsubishi Chemical (code: 4010),
Mitsui Chemical (code: 4183) and Shin-Etsu Chemical (code: 4063) are
moving to raise product prices by 10-15 percent because higher naphtha
prices threaten to add some 100 billion yen to costs, versus only 43.2
billion yen of parent pretax profits for the 11 leading ethylene
producers in fiscal 2002.

The Japanese economy, long the epicenter of the deflation wave,
appears on the verge of establishing a sustainable economic recovery,
and given the price rises seen in upstream basic materials to date, of
breaking out of the deflation that has plagued the country during the
Heisei Malaise. The next stage of the budding inflationary wave is the
passing on of price rises in primary basic-material products to
intermediary products. Even if Japan's economic recovery is
sustainable, the rise in upstream basic-material prices will not be
seen in downstream final products until a year or a year and a half
from now.

The surprising strength in Japan's economy in 2003 helped to erase
expectations that Japan's economy would be entrapped in deflation for
the next 10 years. But the sharp back-up in bond yields only served to
confirm that the major bottom in Japanese government bond (JGB) yields
and a sustainable recovery back to a more "normal" monetary policy and
JGB yields (3-4 percent) are still some time away. Both the Fed and
the Bank of Japan (BOJ) are adverse to prematurely abandoning their
deflation watch in favor of a shifting concern toward inflation.
Neither apparently wants to risk the inevitable correction in
financial markets that would be triggered by a shift in monetary
policy stance because: a) It could be brief but virulent; b) it could
derail the budding economic recovery; and c) it could have negative
implications for the incumbent White House administration in a
presidential election year.

Thus central banks, led by the Fed, are likely to err on the side of
reacting too slowly to emerging inflationary pressures. Conversely,
the US and Japan economies, given the substantial amount of stimulus
already in place, could well continue to be stronger than skeptical
investors are willing to admit. When the Fed does eventually move on
monetary policy and the BOJ admits that Japan's deflation has been
eradicated, we could see the kind of dramatic response in bond yields
that we saw in Japan in June 2003, the second leg of an emerging bear
market in bonds.

This will be a particularly delicate time for the stock market. During
the four years after 1982, two of the main supporting factors behind
the stock market's advance were falling commodity prices (low
inflation) and rising bond prices (falling interest rates). In the
spring of 1987, the CRB index turned sharply higher, hitting the
highest level in a year. At the same time, bond prices went into
virtual freefall. The change of directions in these markets removed
two important bullish props for the stock market.

The stock market rally continued another four months into August 1987,
but bond prices had already peaked four months ahead. By October 1987,
bond yields had climbed to above 10 percent (up 271 basis points year
on year). This jump in interest rates, more than any other factor,
caused the October 1987 stock market crash. The dollar, which had been
declining earlier in the year, started to rebound in May 1987. This
dollar rebound ended in August, as the stock market peaked, and both
markets fell together. A second rally during October 1987 also
failed, and the subsequent dollar plunge coincided closely with
the stock market crash. Japan's Nikkei index and other global equity
markets were dragged down with the sell-off in the US market.

From a long-term perspective, the 1987 sell-off was but a blip on
the stock market's radar screen despite the hullabaloo the "crash"
caused among investors and regulators at the time. In effect, it was a
nasty but short-term correction in a secular bull market. Money Watch
believes that such conditions could exist in 2005.

Global stock market performance has waned over the last month, as the
IT sector has run into profit-taking. The basic-material sector has
rebounded sharply after consolidating for most of the new year, but
the sector doesn't appear strong enough to seriously challenge
previous highs, particularly as the price of gold has slipped under
$400 an ounce. Instead, more "defensive" consumer staples like
financials and utilities have led along with the late-coming telecom-
services sector. This is ironic because these sectors are usually
considered interest-sensitive sectors. The relative performance of
these sectors indicates that investors are willing to take the Fed at
its word for now that it will not be hasty in deciding when to move to
"normalize" monetary policy.

The relative performance of the Japanese market, which had begun to
lag behind global markets after hitting an interim peak in the last
quarter of 2003, has again picked up to the point that the Japanese
market is again outperforming its global peers over the past month.
Japan's IT sector, reflecting the selling pressure globally in the
sector, has begun to lag behind the market as a whole after leading
during most of the first quarter. In addition, Japan's telecom-
services sector has shown a negative correlation with its global peers
over the past several months and remains the worst-performing sector
of the S&P Japan 500.

NTT Docomo (code: 9437) has lost substantial momentum from the heady
days of the previous IT bubble that peaked in 2000. The company is
experiencing soaring marketing costs for its FOMA 3G handsets that
could cause a full year profit decline in fiscal 2004. The street
fears a profit decline as average revenue per user (ARPU) declines
despite wider use. As some 80 percent of FOMA purchasers are existing
customers who upgraded, the company is effectively cannibalizing its
user base.

Vodafone K.K. (code: 9434) is also experiencing a rough spot following
the takeover of Japan Telecom. It now expects a wider net loss of 114
billion yen on slowing growth in subscribers amidst intense
competition. Cuts in phone charges last fall also hurt earnings, and
revenues are expected to fall 8 percent. Conversely, KDDI (9433)
expects to double its pretax profit due to its much higher net
increase in subscribers than the other two mobile phone companies. The
company has been leading the monthly net subscriber race of late,
having recorded the largest net increase in subscribers for the fourth
month in a row in January. Unique features such as walker navigation,
FM radio reception, flat-priced data communications and the
availability of CD quality ringtones for all mobile phone models have
been supporting demand.

With cumulative subscribers in Japan now at some 80 million versus a
total population of 110 million or so, it appears that with shrinking
growth in the overall pie, mobile-phone producers increasingly need to
produce growth in ARPU to keep profit growth rates up. As the market
begins to mature, it is increasingly a zero-sum game where market
share and ARPU increases come at the expense of creditors. In other
words, KDDI's gains effectively come at the expense of NTT Docomo and

Despite KDDI's recent successes, investors are treating the stock
prices of all three companies as if the mobile-phone market has
become a zero-sum game. Docomo's stock price is down 12 percent so
far this year, while Vodafone's is off 22 percent, and KDDI's has lost
13 percent. Given the high-growth expectations already embedded in
stock prices, these companies have to surprise on the upside just to
meet the growth expectations the stock prices already are discounting.
It is also increasingly clear that the highs set in these stocks
during the previous IT bubble are similar to gold being sold for $800
an ounce during its previous bubble: It is unlikely to be achieved in
the current lifetimes of most investors over the age of 40. This is
because the ultra-high growth rates discounted during the previous IT
bubble were not sustainable then and are even less achievable now.

Encouraged by good economic news and growing confidence by domestic
investors that this economic recovery may indeed be sustainable, the
Tokyo market has gotten renewed vigor despite structural unloading of
shares by domestic institutions ahead of the March-end book closings.
One of the main sectors driving the market of late has been the retail
sector. Because of the ravages of deflation and the negative impact
that the Heisei Malaise has had on personal consumption, the retail
sector until mid-2002 was a major drag on the aggregate Japan indexes.
Retail was suffering from a double punch: Not only were sales volumes
depressed, but deflation was ravaging profits in a sector where profit
growth was as much dependent on pricing as it was on volume growth.
Now that investors are on "end of deflation" watch, it was only a
matter of time before sector rotation came around to the late-
coming retail sector. All that was needed was some positive news.
Market participants got that positive news in the form of improved
personal consumption indicators in January, when METI revised upwards
its outlook for the sector for the first time in 20 months. Moreover,
the numbers seemed to suggest that the retail sector has already seen
the worst.

The Topix retail sector has actually been performing in line or
slightly better than the overall market since the May 2003 lows. But
it was not until December 2003 that this became obvious, as the
aggregate indexes began to consolidate and waffle. Certainly, the
retail sector had been a late-coming sector, and from this standpoint,
was "defensive," A bigger factor, however, is growing expectations for
the end of deflation in Japan, and what this will mean for pricing in
domestic sectors such as the department stores and supermarkets.

However, many stocks in the retail sector have recently gone
ballistic, which would indicate a short-term blow-off in stock
prices. Since late February, for example, the stock price of Ito
Yokado (code: 8264), the beleaguered Fast Retailing (code: 9983)
and Aeon (code: 8267) have soared, and this after a "stealth"
rally since November. A cynic would insist that this is merely the
final phase of the rally that began in the first quarter of 2003. But
Money Watch is not a cynic in this case. We are among those who
subscribe to the view that Japan is on the verge of breaking out of
its Heisei Malaise.

Money Watch believes that while the retail rally is the final phase of
the first leg of the next secular rally, the Japanese economy and
stock market will have a second and third leg. The second leg could
carry the Nikkei index to the 14,000 level by July.

-- Darrel Whitten

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