MW-72 -- The Hair of the Dog that Bit You

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

Issue No. 72
Tuesday, April 13, 2004

@@ VIEWPOINT: The Hair of the Dog that Bit You

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@@ VIEWPOINT: The Hair of the Dog that Bit You

The Bottom Line:

o For US investors, the March job numbers were too good to be
true. Yet while they were looking for reasons to disbelieve
the reported numbers, other numbers were announced that tended
to support the bullish economic thesis as implied by the jobs
numbers. The US bond market and the dollar are not waiting
around for official sanction of the employment numbers; they
are already discounting bullish economic scenarios as implied
by the numbers, which is bad news for US bonds, good news for
the US dollar.

o Economics isn't called the "dismal science" for nothing. Just
as markets were beginning to discount upbeat economic news and
even the IMF was talking about a "sweet spot," economists
began to fret about China and how a slowdown there could
derail the Japanese recovery and recoveries in other Asian
nations. But if one subscribes to a hard landing scenario for
China, one has to be bearish on all global equities. Moreover,
the implication of "mega-trend" analysis by Goldman Sachs,
Standard Life and others indicates that the global economy
will be much different by 2050, with the BRICs (Brazil,
Russia, India, China) in the ascendancy as the traditional
OECD nations are overtaken to the point that the G-6 (the US,
UK, Japan, Germany, France and Italy) in 2050 could well be
composed of a very different group of nations. Rather than
despair for Japan, one needs to take a hard look at euroland
if these mega-trends have any credibility. In short, the euro
is significantly overvalued versus these mega-trend

o We continue to believe that Japan's recovery is not a fluke
and that most of the bear story about Japan is now old news.
In short, Japan is now in an economic "sweet spot." Global
investors have confirmed that both the economy and financial
sector are not about to fall off a cliff, while there is still
a lot of skepticism about the dollar. In addition, the
economic fundamentals of the euro are looking noticeably weak
compared to the recoveries being seen in Asia -- an
overheating Chinese economy notwithstanding. Japan may not be
poised to rule the industrialized world (as was implied in
"Trading Places" many years ago), but she is now in the best
position in perhaps the last 10 years to shed the pall of the
Heisei Malaise.

o Nowhere is this more noticeable than in the stock prices of
Japan's major banks. Two weak banks, UFJ and Mizuho, have
soared 613 percent and 627 percent, respectively, over the
past year as Japan came back from what was perceived as a
brink when the Nikkei index hit 7,600. Ironically, the banks
thought most likely to survive have lagged, but nevertheless
handily outperformed the market as a whole. For example,
Mitsubishi Tokyo Financial Group appreciated 161 percent
versus a 55-percent gain in the Nikkei as a whole.

o This is a classic case of "the hair of the dog that bit you,"
which is an old saying among those continually regretting
having had too much to drink the night before. The best
antidote for that horrible hangover, the common wisdom goes,
is to have more of what caused the hangover in the first
place; if the Japanese banks were your nemesis during the
height of the Heisei Malaise, they are your cure for the Japan

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@@ VIEWPOINT: The Hair of the Dog that Bit You

US economists hardly believed their eyes when the March jobs number
hit their Bloombergs on April 2. Some were suspicious of the fact that
the US futures market went crazy about 90 minutes before the
announcement of the official figures, as S&P futures were up big and
fast before anyone supposedly saw the numbers. The cynics saw many
holes in the job number, which, in their opinion, did not add up with
the other numbers: a) the unemployment rate increased to 5.7 percent;
b) wage growth was less than expected at 0.1 percent; c) the "employed
population ratio" actually fell to 62.1 percent from 62.2 percent; d)
the "employment participation rate" was unchanged at 65.9 percent; e)
total employment was unchanged at 138.3 million; and, most
importantly, f) the average workweek fell 0.1 to 33.7 hours, a 40-year
low. Moreover, there were some estimates that of the 308,000 jobs
which were supposedly created, 296,000 were temporary or part-time

But last week, US 10-year treasury notes fell for a third straight
week, the longest slide since October. That's because there were other
numbers to give credence to the March jobs report. Last week, the
number of Americans filing initial claims for jobless benefits dropped
to the lowest level since January 2001. Claims fell to 328,000, from
342,000 the week before. On Monday, the Institute for Supply
Management said its gauge of US service industries jumped to a record
in March as orders and employment climbed. Since mid-March, US bond
yields have climbed from an eight-month low of 3.65 percent. Last
week, they were up to 4.19 percent, and more traders are suggesting
they will climb as high as 5.75 percent by year-end. US 10-year yields
haven't exceeded 5 percent since mid-2002. Bond investors are more
bearish on Treasury notes than at any time in the past 12 years,
according to a weekly poll by J.P. Morgan Chase & Co. As we mentioned
last week, bond investors are not waiting around for confirmation by
the US Federal Reserve that rates are heading higher, nor are they
believing the cynical view of the jobs report. The currency markets
weren't siding with the cynics either. The dollar jumped to a two-week
high against the yen and held near a four-month peak on the euro,
driven by the prospect of more robust and sustainable US growth.

Japan's Recovery Not a Fluke
Those that are still unconvinced that Japan's economic recovery is
sustainable point out that:

1. China's economy is showing clear signs of overheating, and
it was trade with China that really got Japan's economy
kick-started. Slowing growth in China would remove a major
underpinning of growth for Japan.

2. Japan is rapidly aging, meaning pension and insurance costs
are likely to continue increasing, while the general public
(particularly Japan's elderly) has been dipping into its
savings. This drag will limit Japan's growth potential.

3. Total debt is still high, both in the private and the
public sectors, another drag on potential growth.

4. Japan's exchange rate threatens to breach 100 yen to the

5. Interest rates have nowhere to go but up from here.

6. The government is still plotting to raise both the
consumption tax and various other taxes.

But most of these issues are yesterday's news. Anyone who has been
sitting on the sidelines because of the above issues has missed one of
the best rallies in Japan in the past 10 years. Stock prices can only
run on speculation of future events so far, and any rally that has
continued for a year is more than a fluke, especially given the record
trading volumes the Japanese market is producing. Net purchases of
Japanese stocks by foreign investors likely posted an all-time high of
some 14 trillion yen for the year ended March 31. According to figures
released by the Ministry of Finance, foreign investors' purchases
exceeded their sales by 2.69 trillion yen on a contract basis in
March. The record monthly high far surpasses the 1.8 trillion yen in
net buys posted in July 2003.

China's Overheating Economy
Perhaps the newest and potentially most troubling of the issues
mentioned above is China. China's output has been accelerating since
September of last year. GDP actually accelerated in the first quarter
of 2004 to 9.9-percent growth (versus 9.1-percent growth for all of
2003). Industrial production surged 17.7 percent in the first three
months and in March recorded the highest year-on-year increase for at
least the last five years. Exports rose by more than 34 percent during
the period, yet China's trade deficit increased to $8.4 billion. Even
in 2003, when the trade surplus was $25 billion, it was still down 16
percent year on year. The signs of overheating in China are
increasingly obvious. China's government has promised to clamp down.
Prime Minister Wen Jiabao, fearful of a supply glut developing, told
the National People's Congress that the government would block
investment it deemed "haphazard" or "redundant." In response, the
People's Bank of China moved to tighten monetary policy, raising
interest rates on March 21 and increasing deposit reserve
requirements. In addition, they are trying to constrain loans to
non-steel sectors such as real estate, electrolytic aluminum and
cement. But outsiders are skeptical about the premier's goal of
lowering GDP from 9.1 percent to 7 percent this year. China represents
4 percent of the world economy, but last year it used 7 percent of the
world's oil, 27 percent of its steel and 40 percent of its cement.
Those purchases lifted the fortunes of countries throughout Asia, but
also countries from South Africa to Chile.

A New Economic Engine: The BRICs
However, China is not the only country in the region showing strong
growth. India's economy, for example, expanded at a 10.4-percent pace
in the most recent quarter. Indeed, the entire region accounts for
fully 33 percent of the global economy, well in excess of the US
portion (21 percent) and double the share of the euro area (16
percent), according to Morgan Stanley numbers based on the IMF's
measure of purchasing power. The IMF puts China's share in the world
economy at 12.7 percent, well in excess of Japan's 7.1-percent share
and India's 4.8-percent portion, the next two largest economies in the
region. Over the 12 months of 2003, Morgan Stanley estimates that
surging exports to China accounted for 32 percent of Japan's total
increase in exports. For South Korea, the number was 36 percent,
whereas in Taiwan, fully 68 percent of last year's export growth can
be accounted for by surging shipments to China. In the second half of
2003, Morgan Stanley estimates that surging exports to China accounted
for approximately 30 percent of the 4.5-percent annualized increase in
Japanese GDP. In addition, capital spending drew considerable support
from capacity expansion by those industries that were benefiting the
most from expanded trade to China.

China's impact on global commodity markets is equally profound.
China's ascendancy as an economic engine is important not only for
Asia, but for the global economy as a whole. While the Chinese economy
accounted for only about 4 percent of global nominal GDP in 2003, it
accounted for 7 percent of the world's total consumption of crude oil,
31 percent of coal, 30 percent of iron ore, 27 percent of steel
products, 25 percent of aluminum and fully 40 percent of the world's
total cement consumption.

Yet while most eyes were on China, India could be an economy that
emerges largely unscathed in a China-adjustment scenario. India's
growth dynamic is increasingly tilted toward an IT-enabled emergence
of its service sector. The Indian economy is more closely linked to
US-based outsourcing imperatives than to the ups and downs of the
Chinese economy. Indeed, in Goldman Sachs' crystal ball, the BRICs
(Brazil, Russia, India and China) together could be larger than the
G-6 (the US, UK, Japan, Germany, France and Italy)in dollar terms by
2025 and could account for over half the size of the G-6. Of the
current G-6, only the US and Japan may be among the six largest
economies in dollar terms in 2050 (See link to Goldman Sachs report

Under the Goldman Sachs scenario, Brazil overtakes Italy by 2025,
India outstrips Japan by 2032, Russia overtakes Italy in 2018 and the
UK by 2027. By 2040, China's growth slows to 3.5 percent per annum,
but it nevertheless becomes the world's largest economy by 2041 in
dollar terms.

Projections by Standard Life Investment show a similar result.
According to Standard Life, the stock markets of the BRICs economies
represent only 5 percent of the world's total equity capitalization;
the US is by far the dominant market. But if the positive population
forecasts of the US Census Bureau come to fruition and the BRICs'
economic progress follows a similar growth profile to that of Germany
or Japan in the last 50 years, their stock markets will grow
dramatically. Their conservative projections indicate that the BRICs'
stock markets could be nearly as large as the world's four major
economies by 2050. Under the Standard Life scenario, the US will
remain the largest market at around 45 percent, but China will have
grown to become the second largest market at around 25 percent. India,
Russia and Brazil together will be nearly as large as the combined
stock markets of the UK, Japan and Germany.

Over the next five years, China's GDP per capita is expected to grow
at an average of 11.2 percent a year, Russia's by 10.3 percent,
India's by 7.5 percent and Brazil's by 6.3 percent. The equivalent
projections for today's giants are just 1.7 percent for the US, 0.9
percent for Japan, 2 percent for Germany, 1.9 percent for Britain and
1.5 percent for France.

Having survived the so-called "Asian Century" (whereas the US actually
increased its economic and stock market dominance), we are
understandably jaded about such predictions. But the potential for
China, long on the radar screen, is actually coming to pass. Yet the
"China card" is but one indicator of a changing global economic
landscape. While the dominance of the US in the global economy and
stock markets is set to wane, Western Europe increasingly gets left

Another example is South Africa. While it won't qualify as a giant,
South Africa is likely to see its economy grow from $83 billion in
2000 to nearly $1.2 trillion by the middle of the century. What does
that say for the vastly over-inflated euro? According to the Bank of
Japan, "Examination of various features of the global economy yields
two factors which have provided the driving force behind the world
economy in recent years. These are, firstly, the unfettered
participation in the world economy of many emerging economies led by
China; and secondly, the deepening of the IT revolution. These factors
have exerted pressure equally on all developed economies across the
globe to change their industrial structures. But there have been
differences in individual countries' capacities to respond to this
pressure. These differences in responsiveness have depended firstly
upon industrial structure.

The higher the proportion of manufacturing industry in an economy, the
more difficult it has been to respond. This explains the difference
between the US and the UK on the one hand, and Japan and Germany on
the other. Secondly, responsiveness has depended on the degree of
flexibility in the economic structure. Issues such as the state of
corporate governance, the flexibility of the labor market and the
flexibility of the financial structure and the political
administration have all proved relevant. (source: BOJ -- "An Update on
Recent Financial and Economic Developments, and the Conduct of
Monetary Policy," February 2004).

Thus by 2050, Western Europe could be the economic wannabe, with its
four leading economies -- the UK, Germany, France and Italy --
enjoying a combined output of less than half India's and a third of
China's. Both Brazil and Russia will be twice as large as any single
Western European economy. Anyone doubting how things can change (as
pointed out in one unnamed blog in cyberspace) should go and see
"Gangs of New York" and look at the US 20 years later. The bottom line
is that strong growth will catalyze institutional changes. Those who
underestimate China's ability to cope with its growth and growing
influence in the world economy ignore history. While Japan will not be
at the helm of this mega-trend, they certainly will benefit more than
Western Europe.

According to the OECD's December 2003 economic outlook, China was
supposed to grow 7.8 percent in 2004 and 7.4 percent in 2005, with
Brazil growing 3.0 percent and 3.5 percent, respectively, and Russia
growing 5.0 percent in both years. The total OECD zone was to grow 3.0
percent and 3.1 percent, respectively, the US 2.7 and 2.9 percent, and
Japan 1.1 percent in each year. All are now generally expected to grow
faster in terms of real GDP.

David Burton, director of the Asia and Pacific department of the
International Monetary Fund, wrote, "Asia already showed considerable
resilience last year. The SARS outbreak and geopolitical uncertainties
slowed the momentum in most economies, but only temporarily.
Supportive macroeconomic policies and the recovery of the global
economy helped the region to bounce back in the second half of the
year. Propelled by a resurgence of domestic demand and the highest
export growth in nearly three years, non-Japan Asia was once again the
fastest growing region in the world."

"In spite of surging intra-regional trade (not least that involving
China), emerging Asia continues to depend heavily on economic
developments in the rest of the world," Burton continued. "Exports
between countries in the region have risen steadily from about 20
percent of total exports in the late 1970s to about 40 percent in
2002. However, perhaps only about half of this trade is going to meet
intra-regional final demand. Thus, the bulk of the exports of Asian
countries is still linked to economic activity outside the region. The
recovery in the global economy, although still uneven, is
strengthening and broadening. In particular, growth is rapid in the
United States; it is picking up in Japan, led by investment and
exports; and, although still lagging, it shows signs of revival in the
euro area as well. Overall, the IMF's forecast for global growth will
likely be revised upward in the forthcoming world economic outlook."

"Given the growing regional interdependence mentioned earlier,
downside risks also arise from the possibility of a much sharper
slowdown in China than foreseen in the baseline," Burton added. "Our
central scenario is for a soft landing, but a more abrupt slowdown
remains a possibility if China is not successful in striking the right
balance between preventing generalized overheating and avoiding a
large decline in investment. It is perhaps a reflection of how dismal
our 'dismal science' is, or perhaps just a reflection of human nature,
that the list of downside risks usually tends to be longer than the
list of possible surprises on the upside."

Conversely, Asia's ability to cope with external shocks has come a
long way since the Asia crisis. Most countries in Asia now have far
greater resilience than when the Asian currency crisis hit. The key
strengths include abundant or more than abundant official reserves,
more flexible exchange rates and stronger corporate balance sheets,
including those of the banks.

As we have pointed out repeatedly, the stream of economic news on
Japan points to a deepening and broadening of the economic recovery
driven by grass-roots recovery. Japan's economy recently got an upbeat
assessment by the central bank and positive figures for investment in
the form of new machinery orders. This is reflected in the views of
overseas investors, where a growing number of US money managers and
investors are convinced that Japan's market has finally turned the
corner and that the 58 percent rise from 2003's market lows is a
prologue to greater gains. To some, the disconnect between foreign
enthusiasm and local skepticism in Japan is reminiscent of South Korea
in 1998 and 1999.

At some point, domestic investors will get the joke -- a sustainable
recovery is under way. There is already evidence that domestic
investors in Japan, both individuals and, belatedly, institutions,
have increased appetite for risk, which usually implies higher equity
allocations. Last year, Japan's battered corporate pension funds
managed in "group" accounts at the major life insurers recorded their
first positive returns in four years for a 16.6-percent gain.

Public pension funds have spent the last few years trying to increase
the weight of passive investments, to the point where the ratio of
passive investments has risen beyond the target of 70 percent. From
the new fiscal year begun April 1, active investment has become the
asset allocation of choice. From July of last year, the Yucho and
Kanpo public pension funds were allowed to give mandates to asset
managers. At the end of March of this year, they had chosen eight new
active managers for allocations.

These fund pools account for some 8 trillion yen of investments, of
which some 1 trillion yen is now in "active manager" hands. As the
appetite for risk among both individual investors and domestic
institutional investors continues to increase, stock selection will
become ever more important. In other words, it will no longer be
enough just to be in the benchmark index, the Topix. As the weight of
pension funds managed by active asset managers increases, the
performance gap between stocks with attractive fundamentals and those
merely in the benchmark index will continue to widen. The Topix is
looking a little over-extended vis-・vis its 65-day moving average,
thus a "speed adjustment" could come at any time.

Year to date, while the S&P 1200 Global index is up only 3.4 percent
and the US up a more tepid 2.5 percent, the S&P Japan 500 has been on
a relative tear, appreciating 14.3 percent during the same period. On
a market-cap weighted basis, the banks have been driving the rally,
accounting for 4.95 percent of the total gain, followed by the
industrials sector at 2.67 percent, IT at 2.46 percent and industrials
at 2.67 percent.

The rallies in the bank stocks reflect recovering balance sheet
health, increased leverage to an indigenous economic recovery and
continuous low rates as well as excess liquidity. Ironically, while
Shinsei Bank had a favorable debut this year, the bank is not the
favorite of analysts assuming an optimistic recovery or even a modest
recovery. This is because the bank is currently structured to benefit
more from restructuring and corporate revitalization. But with
essentially zero credit costs, there is almost no leverage to
declining credit costs due to a better-than-expected economic
recovery. The same can be said for Tokyo Mitsubishi Financial Group.
The banks that have the highest leverage to an optimistic scenario or
even a modest recovery scenario are actually those banks that were hit
the hardest by investor selling to the 7,600 low on the Nikkei index
at the height of pessimism about Japan's economy and the viability of
her financial system. Moreover, the government's move to rescue Resona
Bank also showed investors that the government is willing to rescue
the weaker of the major banks before letting a failure to present a
threat to the viability of the financial system. In other words, the
weakest banks have the highest leverage to a sustainable recovery in
Japan's economy.

This is reflected in the relative performance of these three major
banks over the past 12 months. All have massively outperformed the
Nikkei, but while the Tokyo Mitsubishi Financial Group has appreciated
a handsome 162 percent, its weaker peers, UFJ and Mizuho, have surged
613 percent and 627 percent, respectively. That is indeed a case of
the "hair of the dog that bit you."

-- Darrel Whitten

Goldman Sachs report on the BRICs

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Written by Darrel Whitten

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