Caution and wise buys put Japan in recovery position

Japan has often failed to live up to expectations and as fund managers again begin to get excited about the world’s second largest economy the question remains whether this time will be another false dawn.

John Alkire, the chief investment officer for Japanese equities at Morgan Stanley Investment Managers, however, says he is willing to claim that “this time is different”. Fundamental to this, says Alkire, is that Japan’s relative position on the global stage has shifted over the past 12 months owing to its lack of exposure to the toxic assets that have sent stockmarkets tumbling.

“Ten years ago Japanese banks were nationalised and the FSA [Financial Services Agency] instituted a stringent oversight policy which has prevented them from buying up these toxic assets,” he says.

According to data from Bloomberg the total global losses taken from writedowns of so-called “bad loans” was $494.4 billion (£279.7 billion) as at August 13, 2008. Of this, institutions based in the Americas were forced to write down $252.6 billion of bad debt, with Europe suffering a $229.3 billion loss.

In total, therefore, the two regions accounted for 97.5% of the total amount written down leaving Japanese companies with the relatively modest figure of $12.5 billion of toxic assets taken off balance sheets.

Following the bursting of the asset price bubble in Japan, which saw the Nikkei 225 index fall from its 1989 peak of 38,957 to 7604 in April, 2003, the business ethos in Japan switched to an extremely cautious saving mentality. This has led to 45% of Japanese companies becoming debt free, compared with just over 20% of American firms, and Japan as a nation becoming a net creditor.

“Japan is a net creditor and personal and corporate finances are in good shape,” says Simon Somerville, manager of the Jupiter Japan Income Fund. “The improvement I’ve seen in corporate governance has also been fantastic.”

Both Alkire and Somerville note that in the liquidity squeeze, cash rich, debt-free companies can benefit from attractive valuations while other firms are forced to deleverage to prop up their balance sheets. Already merger and acquisitions (M&A) have picked up with year-on-year volume of M&A activity increasing by more than 300% in the first half of 2008.

Somerville says the important factor is that, unlike in the past, Japanese firms have been buying overseas assets in areas where they already have expertise. An example of this can be seen in the purchase of Ranbaxy Laboratories, India’s largest pharmaceutical company, by Daiichi Sankyo, a Japanese pharmaceutical company, for $5 billion in June.

The problem with this glut of positivity on Japan can immediately be seen in the performance of the country’s leading stock index over the past year. Despite its lack of exposure to the subprime mortgage debacle the Nikkei 225 has fallen by 32.5% over the year, which is markedly worse that the 23.8% loss suffered by the S&P 500 index of American stocks. News from the Bank of Japan has also painted a rather glum picture of the country’s short-term prospects. The Tankan survey, a quarterly poll of business confidence conducted on behalf of the central bank, shows the year-on-year forecast for 2008 profits across all industries in Japan was revised downwards by 3.8% to a decline of 8.1%.

Michael Taylor, a senior economist at Lombard Street Research, says economic data suggests Japan is likely to see a recession this year, albeit a short-lived one. “We think the situation will remain negative for the rest of the year with Q3 and Q4 showing negative growth,” says Taylor. “However, we think that Japan is well positioned to recover.”

The recent appointment of Stanford-educated Taro Aso as prime minister has helped fuel the confidence of some Japanese fund managers. Alkire says the new man could be “the most important prime minister in the last 50 years” as his popularity and business background have prompted hopes that he will be a catalyst for recovery.

The consensus, however, is that the only way in which this recovery can be achieved is if domestic investors start buying back into Japanese equities, and wean themselves off the fixed income addiction that has been built up. In this regard Taeko Setaishi, fund adviser for Atlantis’ Japan funds, says the appointment of a new prime minister will not have a great effect.

“I don’t think it makes much difference who is appointed prime minister,” she says. “Both companies and individuals have money to invest in the stockmarket but the situation [in global markets] is changing so rapidly and it is hitting Japanese companies.”

With the global credit crisis still playing out, Japan’s economically sensitive stockmarket is likely to have to go through some more pain before it starts to recover.

While this will affect the Nikkei’s performance over the near term it should also mean it is more reactive to positive economic news than other global indices.

Setaishi says she is not yet convinced that domestic investors are poised to return to equity investing just yet.

“I think domestic investors could come back into the stockmarket but it is unlikely in the next six months now that the economic outlook is going down,” she says. “We thought companies’ expectations were too optimistic and from now many companies will be issuing downwards revisions to earnings.”

Key to this problem is that despite China replacing America as the country’s largest trading partner, Japan remains more sensitive to economic events in America than its neighbour.

With the economic outlook in America looking progressively bleaker, this has spurred fears that Japan will take longer to see the benefit from positive fundamentals and a market that has never been so under-owned in its history.

Taylor says a possible unforeseen benefit could help speed up this process with Japan currently suffering from externally driven inflation.

“While this inflation has been bad in one way it is encouraging people to change their asset allocation,” says Taylor. “We are positive on Japan but then we’ve been there before.”