MW-74 -- The Inflation Worm Turns

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

Issue No. 74
Thursday, April 29, 2004

@@ VIEWPOINT: The Inflation Worm Turns

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@@ VIEWPOINT: The Inflation Worm Turns

The Bottom Line:

o The US Federal Reserve is trying to prepare the markets for an
eventual tightening of monetary policy. This has some in the
US comparing the current situation to 1994, when US bond
yields leapt on a series of aggressive rate hikes that totaled
250 basis points. US 10-Year treasuries are already up almost
100 basis points from eight-month lows last month.
Historically, a "neutral" position for Federal Fund rates has
been 200 basis points (2 percent) above inflation, but some
suggest that a "neutral" Federal Fund rate is more like 4
percent, which would put 10-Year TBs at 8 percent! The
implication is serious market volatility and a nasty US
correction, even in the context of a bull market. This has the
bears cautious on almost every single asset class with risk
attached, even "safe" havens such as gold and US treasuries.

o On the other hand, the consensus is that: a) yes, US rates are
going up, b) but not for a while and c) gradually when they
do. Historically, the relationship between US rates and the
stock market has been "three steps and a stumble," meaning
that the stock market usually does not begin to feel the
impact of higher rates until the third round of tightening by
the Fed. Recently, merely the hint of higher rates has the
financial markets shuddering. The reason is leverage: a)
households and businesses are still highly leveraged, b) as
are investors and traders.

o The trigger remains US job growth. Assuming job growth, the
Fed's best timing to shift to tighter monetary policy is on
June 30. If it does not move on June 30, CRB prices could
renew highs as could gold; the US dollar will sell off again;
and US treasury yields could soar, placing the Fed behind the
eight ball. What the US market faces is a secular, multi-year
upward movement in rates that will track a resurgence of

o As for Japan, the wild card is China. China is the locomotive
that is driving Asian economies and as much as 30 percent of
Japan's recovery. The popular notion these days is that China
may be headed for a hard landing, with runaway money supply
growth, huge inflows of foreign investment and businesses
responsible for the "over" investment not that dependent on
bank loans. If China slams on the brakes, the recovery in
Japan sputters and so does Japan's stock market.

o Last week, we pointed out that virtually everyone is now
bullish on Japan -- and that makes us nervous. Given the
substantial appreciation in Japanese stocks in 2003, 2004 will
be hard-pressed to beat such gains. How much of a bearish
China scenario is already discounted? We suspect very little.
A quick glance at Jasdaq, which has soared over 160 percent
during the past year, indicates to us that the risk-reward for
the Japanese market has noticeably deteriorated. If this is
the beginning of a "megatrend" recovery for Japan, these
concerns will mean very little. However, investors will also
suffer relatively little if they wait for clearer direction
from global markets. The moral of the story is: Now is not the
time to chase prices because a mid-cycle correction is

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@@ VIEWPOINT: The Inflation Worm Turns

In retrospect, the dreaded 1994 scenario was not such a big deal,
considering the gains made in the S&P 500 after that. Indeed, the
sharp uptick in US treasuries was about 206 basis points in terms of
monthly levels, versus the 100-basis-point back-up in yields already
seen from historical lows. It merely caused the S&P 500 to mark time
for a number of months but did not cause a serious market correction.
The S&P 500 went on to bigger and better things, appreciating some 360
percent from those levels, as the secular decline in interest rates
was far from over. Long-term rates in terms of 10-year treasuries fell
another 200 basis points after this mid-cycle spike.

In reality, the current market phase is much different than 1994. We
are at the bottom of an historically significant decline in interest
rates. Investors are concerned that US rates may be headed back toward
4.50 percent over the next decade as inflation re-asserts itself.
Long-term deflation in terms of long bond yields did wonders for US
equity performance, while long-term appreciation in bond yields
implies much more mundane returns on equities in the next decade than
seen in the past. In this respect, comparisons with 1994 are a red

The US bears also point out that the current rally began with
price/earnings multiples at higher levels than they have ever been at
the bottom of a market cycle. When one considers the historically low
level of interest rates and market capitalization ratios (P/Es) from
the standpoint of interest-rate adjusted market capitalization ratios,
historically low levels of interest rates would also imply
historically high nominal P/Es from which the current rally began. In
addition, interest rates are not the only market story. For example,
the correlation coefficient (R-squared) of 10-year US TB yields and
the S&P 500 around 1994 was minus 0.421 -- a significant but not
all-encompassing factor affecting stock prices.

The year 1994 represents a self-reinforced inflation scare. Between
1992 and 1996, the CRB Futures index rallied between 25 and 30
percent, but the urban consumer price index in the US hit 3.3 percent
in January 1993, fell to 2.3 percent by May 1994, and was down to 2.1
percent by October 1997. This time, the CRB futures has rallied more
like 50 percent and has broken out of a 20-year downtrend. Yet there
are those who still suggest that the global environment is still
basically deflationary because of the emergence of new global
competitors from the old iron curtain/communist countries that had
heretofore not been counted in the global economy, such as China.

Such views overlook a basic feature of developing versus developed
economies. Companies in developing economies have relatively low labor
costs at first but relatively expensive capital equipment costs, where
tradable capital goods are priced at international market levels.
Because labor costs are lower, these companies tend to be more labor
intensive. But as a country's economy develops, wages rise regardless
of whether or not labor becomes unionized. The relative share of
production inputs naturally shifts from labor to capital, and
companies in developing nations become more capital-intensive.

The real investment issue is, which is more inevitable, global
deflation caused by low wages in China, or a revaluation of relative
currency values in such nations as their economies become more
developed and the relative share of production inputs shifts from
labor to capital? As China's relative importance in the global economy
continues to expand, China is finding it increasingly difficult to
maintain its artificial peg against the dollar. Its efforts to protect
this peg to date have led to soaring domestic money supply and credit
availability. If China is to continue expanding its role in the world
economy and at the same time avoid a nasty hard landing in its
domestic economy, a currency revaluation is inevitable. That would
reduce currency deflationary pressures on the developed economies.

With fears of a hard landing and the bursting of an excess credit
bubble in China, Japan is now the darling of global investors. They
see more risk in a US market that has growing twin deficits, doubtful
sustainability in the dollar's value and relatively expensive
valuations both in terms of US market history and vis-・vis markets
such as Japan. On the other hand, Euroland has become the laggard of
the world economic recovery and now has a single currency that is
generally considered over-valued.

But just as Nasdaq has been the bellwether for the recovery in the US,
Jasdaq has been the bellwether for the recovery in Japan. Jasdaq has
now appreciated over 160 percent from the lows in early 2003 and has
recovered roughly 73 percent of the levels lost in the post-bubble
sell-off at the end of the last decade. All this with but a brief
consolidation in the fourth quarter of 2003. In other words, Jasdaq
appears to be forming a secondary bubble, driven by active individual
investor trading.

Big Fish in the Jasdaq Pond
With few exceptions, the top firms in terms of market capitalization
on Jasdaq are priced at very bubbly valuations. Rakuten, which has
taken over king-of-the-hill market cap ranking since Yahoo moved to
the big board, is reporting minus return on equity (ROE) and return on
assets (ROA), but has a lofty price- book-value ratio (PBR)of 37.2x.
We doubt if Shuhei Abe of Sparx Asset Management, ranked number two in
market capitalization, would purchase a stock with a P/E ratio of 610x
and a PBR of 44.9x that is producing ROE and ROA in the mid-3-percent

These are but a few examples of the fluff that has developed in
Japan's smaller cap companies, which have become the playground of
domestic individual "momentum" day traders. Indeed, Sparx Asset
Management's stock has soared 1,370 percent over the past year, versus
a "mere" 458-percent gain for Rakuten and a 312-percent gain for
Index. During the same period, the Nikkei 225 is up 54 percent. Given
the current valuations of these stocks, the implied medium-term
earnings growth required to justify current stock price levels is
simply not achievable.

Meanwhile, other stocks in the top-10 of Jasdaq market capitalization
look positively cheap in comparison. Take, for example, Citizen
Electronics (code: 6892), which is selling at a nominal price-earnings
ratio (PER) of 23x while boasting a ROE of 6.6 percent; or Aruze
(6425), which is selling at a very attractive 12x earnings with a
substantial ROE of 14.7 percent. Because the smaller markets in Japan
-- the second section of the Tokyo Stock Exchange and Jasdaq -- are
poorly covered by a shrinking pool of sell-side analysts, analyst
coverage and market liquidity suffers accordingly, leading to a
greater degree of mispricing.

Despite the obvious froth in some stocks, however, Japan's secondary
markets still present the largest number of stocks with the best
potential upside for foreign investors who do their homework.

-- Darrel Whitten

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Written by Darrel Whitten

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