Japan not insulated from global dip

Although Japanese economic growth remains strong quarter on quarter, much of this is a result of external factors, leaving the economy vulnerable to a fall in exports to America and China.

As had been widely anticipated, third-quarter Japanese GDP data suggests industrial production has peaked. This softening appears to spike the argument that Japan can grow in a weakening global economy and tilts the debate conclusively in favour of those who take the view that it has not decoupled from the rest of the world.

Admittedly, the economy is in better condition this time around than it has been during previous global economic dips, as the structural problems seen in the past have all but gone, but Japan clearly remains cyclical.

Although the figure is relatively strong, at 2% quarter on quarter annualised, most of this tally can be attributed to external factors. Exports remain strong, particularly autos, basic materials and capital goods, which continue to benefit from sustained demand from China. The external sector is still crucial and if export volumes fall, the resultant decline in Japanese industrial production will hit profits and confidence, and have a damaging impact on domestic spending plans.

Auto manufacturers have raised exports to America to meet demand for new models. However, the Democrats’ mid-term election success poses the possibility America may apply greater political pressure to slow this trend. Other potential threats to the auto sector are the deteriorating American product mix and the reintroduction of generous incentives by the “Big Three” American automobile manufacturers – Daimler Chrysler, Ford and General Motors – before the end of this year.

Capital expenditure surveys remain particularly strong. In addition, the owner-occupied housing market is belatedly showing signs of life as land prices rise and the effects of the decision to abandon zero interest rate policy (Zirp) work their way through the system.

Growth in bank lending is decelerating. This is partially due to a fall-back from the levels attained in the rush to finance before the end of Zirp, and partially a year-on-year effect as, in 2005, mega-banks were still “guided” by the Financial Supervisory Agency to lend to smaller companies. Now, without their reliance on public funds, banks have the freedom to be more commercial. Credit creation has always been the missing link in the reflation story. This could offer a further leg up in corporate Japan, but the process will be gradual and needs monitoring.

As expected, corporate earnings are being revised up, although managements are reluctant to be aggressive in the face of a slowing global economy. There are also signs that investor caution, and in many cases valuations, are limiting the reaction to positive newsflow and upward profit revisions.

Dividend hikes and share buybacks are still increasing in various sectors of the market. The payout ratio is now above 20% and many industry leaders are targeting 30%. Even banks are looking to deliver significant dividend increases once they complete the repayment of public funds.

There has also been a noticeable upturn in levels of corporate activity. Parent companies are buying back subsidiaries and industry consolidation in areas such as leasing has accelerated. During early November, levels of corporate activity increased to such an extent that the market was virtually seeing a deal a day. Takeover premiums have tended to average about 20%. However, there has not yet been a major M&A transaction to trigger a significant and sustained rally.

We had expected to see significant upward revisionsto full-year forecasts at the interim stage, but recent economic data appears to have dented corporate confidence. Full-year pre-tax profit growth is now expected to be 2.6%. With capital expenditure still growing and profit growth slowing, Japanese companies will need to seek external funding.

Consumption has been especially weak and machinery orders have slowed from a high level. The consensus among economists remains that a further interest rate increase will occur in the firstquarter of 2007, but this could depend on economic releases in the remainder of 2006.

Over recent weeks, Toshihiko Fukui, governor of the Bank of Japan, has appeared to be preparing the markets for a second hike. In the short term this could be viewed as a policy error if the global slowdown proves more severe than expected. There remains a low probability of fiscal policy error, especially ahead of next summer’s upper-house election.

Over the coming months, the threat to Japanese markets is likely to come from over-reliance on overseas investors and external demand, most notably from China and America. Another danger is excessive equity supply. Post-listing performance of some recent initial public offerings has been noticeably weak, and the levels of new issues coming to the market remains high.

Possible triggers for market moves over the remainder of this year and into 2007 include the realisation that the domestic economic recovery is not insulated from the global cycle. The market may gain support from bottom-up earnings revisions, signs of releveraging, reasonable valuations and continuing M&A activity. Negative real interest rates should be helpful for markets, while the levels of credit creation and restructuring also look set to provide support.