Japan: Early signs of recovery

The Japanese equity market was relatively resilient in the first half of 2008 compared to other developed markets, especially on a US dollar basis. Japanese companies have restructured over the past decade to streamline non-core businesses and reduce debt, and pricing power has improved due to consolidation in many sectors including banking, retail, steel, and electronics.

During the first half of the year, Japan was seen as one of the few beneficiaries of inflation, after a decade of deflation. Japanese companies have also been optimising the global allocation of resources and are less dependent than before on exports to the US. As the problems in the sub-prime housing market became evident, it was hoped that this time around, the Japanese economy would be able to withstand a moderate slowdown in the US.

However, due to securitisation and leverage, doubt was cast over the value of not just sub-prime but all sorts of securities on the balance sheets of financial institutions around the world. This fractured the trust upon which the global financial system depends, and exacerbated by a couple of false steps on the parts of some governments, led to a full blown global financial crisis in September.

With talk of a global depression, Japan was not immune, and the Japanese equity market underperformed the US during the second half of the year, although it has held up better than Europe on a currency-adjusted basis. It will take time for investors to regain some semblance of confidence, and we are not expecting the Japanese equity market to start its recovery before early summer next year.

The issues are credit, liquidity, the economy and capital flows. The global credit markets are not yet completely functional, preventing the liquidity boosting measures by central banks from reaching the real economy. Credit markets cannot function without confidence in financial institutions; governments and central banks have at last started taking real action, and credibility is recovering.

On the other hand, we are only just starting to see the impact of the financial crisis on the real economy, and still have little real idea of the depth of the coming downturn. As such, equity markets are having difficulty carrying out their function of valuing future company earnings.

Road to recovery

Japanese companies with a large exposure to the global economy cannot remain unaffected by a stronger currency, and investors are unlikely to regain confidence in earnings figures until they see full year results in May next year. Japan is less dependent than before on the US, but more dependent on Asia. Although demand in emerging markets should continue to grow in the long term, they are particularly vulnerable to capital outflows. Of course, Japan is also subject to large capital flows.

One reason for the recent appreciation in the yen is the repatriation of funds from abroad by Japanese retail investors, who had been shifting from low yielding domestic deposits to high yielding foreign currency bond funds. The strength of the US dollar against other currencies, despite the fact that the US is basically printing money, is also partly due to the repatriation of funds as a result of deleveraging, although in the case of the US dollar it is the standard global currency.

Plans for conquest

In contrast, whereas over the past few years Japanese companies have been increasing dividend payouts and share buybacks with the cash they have realised from restructuring, going forward they are relatively well positioned to expand abroad. One recent example is the investment in Morgan Stanley by Mitsubishi UFJ Financial Group. A combination of releveraging, rising ROEs and an end to deflation should help support Japanese equity valuations compared to other developed markets. Thus while there may still be more downside in the first half of 2009, we expect the Japanese equity market to hold up a little better, and show some recovery in the second half of the year.

Although the Japanese equity market as a whole is not overly cheap, there are a large number of undervalued companies. Japan has a large number of globally competitive companies with unique technologies and manufacturing know-how, in energy efficiency and other areas of environmental management for example. However, it is necessary to watch out for value traps. For the greater part of 2008, earnings and valuation factors have behaved seemingly irrationally, with stocks with low valuations and high profitability underperforming those with high valuations and low profitability. The behaviour of these factors should start to normalise in the second half of 2009 as debt spreads and volatility comes down, and the difference between top down and bottom up earnings forecasts closes.