Benefits beckon with global upturn

Falling investor confidence and concerns about world recession have driven the Japanese market close to 25-year lows. But signs point to a strong resurgence when the global economy recovers.

It has been a torrid period for global equity markets. The Japanese stockmarket has had a poor 2008, although this has been offset for foreign investors by the surge in the yen. Notwithstanding its relatively limited direct exposure to the difficulties in global credit markets, Japan suffered from the rapid decline in investor confidence and growing concerns about global recession.

However, despite the gloom and the likelihood of further volatility in the near term, the country is well placed to recover strongly from its cyclical downturn when there is an improvement in the global economy. Given its historically low valuations and its already depressed sentiment levels, we would expect Japan’s stockmarket to benefit fully from such a turnaround.

The Japanese market has fallen sharply, moving close to 25-year lows. Investment conditions in the past few months were as unfavourable as any seen since the bubble burst in Japan at the beginning of the 1990s. Investor sentiment deteriorated sharply, driven by indications of a global recession and poor domestic economic data. Furthermore, the credit crisis stepped up a gear,resulting in the failure or takeover of several high-profile financial institutions, both in America and Europe. Overall, the effects of the turmoil in financial markets are spreading out from America, affecting more of Japan’s key export markets.

The sharp falls in the Japanese market were all the more frustrating for investors because Japan was considered by many to be relatively safe, given its limited direct exposure to the difficulties in global credit markets when compared with other developed markets. It has arguably been safer than other markets, but it was not immune to the sharp deterioration in risk appetite. There are three reasons for that.

First, while Japan was less exposed to the direct impact of subprime, some of the secondary impacts had an effect – through exposure to AIG or Lehman Brothers bonds, for example. The second reason that Japan has not quite been a safe haven is that the markets have begun to focus on the economic impact of the financial turmoil, not just the turmoil itself. Third, investor sentiment is depressed and investors have moved to reduce risk in their portfolios, almost at any cost.

Given the high level of investor uncertainty, we remain cautious on the near-term outlook in anticipation of further market weakness and volatility. It is almost impossible to call the point at which risk aversion will ease and global equity markets will trough. On the positive side, the Japanese economy is in better shape to resist a global recession than in previous cycles. Admittedly, economic data in Japan continues to disappoint and growth estimates continue to fall. However, this downturn is cyclical rather than structural, and may be shallower than that anticipated in most other developed markets, because Japan is relatively less encumbered by imbalances such as high levels of household debt.

Japan did not suffer from many of the excesses that affected other economies during the 1990s. Furthermore, the interbank market has been largely unaffected in Japan, so there are not the systemic structural issues that have hit some of the other developed economies. This is neatly exemplified by the reversal seen in financial flows as Japanese institutions take stakes in ailing western institutions – a reversal of what was seen in the 1990s.

However, export growth, the key contributor to GDP growth over the past few years, is slowing significantly. Exports have contributed disproportionately to growth in previous quarters, although export growth has stalled and GDP has shrunk. The big change has been a sharp fall in exports to Europe – this was not helped by the recent strength of the yen against the euro.

On the positive side, Japan’s largest export market is China, whose economy is still expanding, albeit at a less rapid pace than recently. There is also scope in China to stimulate demand – for example, the Chinese authorities recently announced a significant package to boost infrastructure and housing investment.

It is likely that the outlook for Japanese exporters will also improve if the warning by the G7 group of leading economies of “excessive gains” for the yen brings about a reversal of the recent strengthening.

Furthermore, there is longer-term support for Japanese exports to continue to thrive, given leading technologies and strong global brands.

Further support for the Japanese market comes from valuations, which are in aggregate low relative to history. The Japanese market is oversold, in our opinion, with the aggregate price-to-book ratio now below one.

In addition, the dividend yield on the Japanese market exceeds the Japanese government bond (JGB) yield by some margin (the dividend yield is about 2.8% compared with JGB yields of 1.5%) which historically has preceded a market recovery. Dividends are also three times covered in Japan.

Another important positive for corporate Japan is that although the earnings outlook has deteriorated recently, the sharp falls in oil and commodity prices we have seen represent a significant shift in the terms of trade (Japan is a major commodities importer). We believe that this change will ultimately be reflected in rising profit margins.

Overall, Japan is well-placed to recover from its cyclical downturn when an improvement is seen in the global economic situation, and the equity market should benefit fully from such a turnaround. Sentiment is already at depressed levels, Japan is relatively less encumbered by imbalances such as high levels of household debt than other developed markets, while valuations are historically attractive.