Missing link threatens full recovery

Japan’s lack of a personal consumption dynamic and a reliance on its export market could slow the country’s economic recovery further, especially if demand from China and the US dwindles.

Japan’s recently installed premier, Shinzo Abe, has been preoccupied with international diplomacy rather than his country’s economic and financial performance. Abe’s attention has been dominated by North Korea, the hermit Stalinist state, which on October 9 conducted its first atom bomb test and was subsequently slapped with United Nations sanctions.

The Japanese stockmarket, however, may be signalling that the economy could grab more of Abe’s agenda. The MSCI Japan index has performed poorly this year, falling around 1% between January 2 and November 23 (see graph). This is well behind the 15% rise in the MSCI World index and 25% gain by the MSCI Asia ex-Japan.

Could this be an indication that stockmarket investors foresee tougher times for Japan’s economy in 2007? The Japanese stockmarket has also traditionally been seen as a play on the global business cycle. Hence some analysts might interpret 2006’s poor performance as a possible lead indicator of slowing global economic growth.

Stephen Roach, chief economist at Morgan Stanley, recently detected two concerns on a trip to Japan: deepening worries “over Japan’s lack of a personal consumption dynamic, and its excessive dependence on China [that] was increasingly viewed as a potential risk”.

“The private consumption story has long been the most important missing link in the Japanese recovery dynamic,” Roach says. “Since the onset of the economic upturn in the first quarter of 2002, private consumption has risen at just a 1.6% average annual rate — well below the 2.3% growth rate in overall gross domestic product. As a result, the consumption share of Japanese GDP has fallen from 58% in early 2002 to 56% in mid-2006.”

This makes Japan more dependent on capital expenditure and external demand for economic growth. But many forecasters anticipate slower economic growth during 2007 in both America – following a slump in its housing market – and China, which is striving to cool its economy. The two countries together are key to Japan’s export performance.

“While US consumption has held up quite well so far – providing ongoing support for Japan’s largest export market – there is understandable concern that such support may diminish in a post-housing bubble climate,” Roach says.

“And now there are concerns that a China slowdown may finally come to pass – undermining support for what has become Japan’s second-largest export market. Collectively, the US and China account for fully 37% of total Japanese exports – by far the largest and most concentrated piece of Japan’s external demand.”

However, Japan’s third-quarter GDP grew at an annual rate of 2.7%. The trend in inflation has been upward too, according to Julian Jessop, chief international economist at Capital Economics. This indicates that Japan is continuing its escape from the deflationary torpor it suffered during the 1990s – though few analysts feel the inflation data is strong enough to indicate Japan has completed that escape yet.

Nonetheless, Jessop points out that “Japan is in its longest period of economic growth since World War Two, and yet interest rates are still at an emergency low of just 0.25%”. Hence many commentators expect Japanese interest rates, which were held at zero for an extended period until this year, to rise.

But if America and China do slow next year, robbing Japan of some export-led momentum, then higher rates combined with the lack of a “personal consumption dynamic”, to borrow Roach’s phrase, could lead to slower growth.

“Recent data indicates that the economy has yet to develop the kind of self-propelling momentum that we had expected,” says Hiroshi Shiraishi, an economist at Lehman Brothers.

“With the economy still in a deflation twilight zone, we would feel more comfortable were macro policy focused on producing vigorous growth and quashing deflation.

“But the Bank of Japan is more focused on ‘normalising’ policy and has started raising rates, gradually – although prematurely, in our view. Meanwhile, fiscal tightening continues, in the form of income tax cutbacks and ongoing expenditure cuts, with more looking likely. Fortunately, a hike in the consumption tax seems unlikely before the 2009 financial year.”

Shiraishi says overall “we judge the economy has undergone enough structural repair to overcome these headwinds”. Lehman forecasts economic growth of 2.4% in 2007, down from 2.8% in 2006.

Another concern is the so-called yen “carry trade”. Savvy investors are thought to have borrowed in yen to take advantage of Japan’s low interest rate to invest in assets, including stocks, around the world. But rising interest rates could lead the carry trade to unwind, threatening financial markets.

“We would not expect the Bank of Japan to be deflected from raising rates by the fear that the subsequent unwinding of ‘carry trades’ would disrupt financial markets and cause a sharp rise in the yen,” Jessop says. “Carry trades do not appear to be large enough to represent a genuine systemic threat. But to the extent that the accumulation of these risky positions might be a serious problem, this is surely an argument for raising rates sooner rather than later to prevent these positions from getting even bigger.”

The Japanese stockmarket sits on an estimated price/earnings multiple of 18.7, according to Credit Suisse First Boston – cheap compared with the past but not compared with other markets. The Asia ex-Japan price/earnings multiple is 14.3, according to the investment bank, while the global P/E is 15.5. The bank also forecasts earnings per share growth in Japan will decelerate from 41.7% in 2005 to 8% this year.

Michael Thomas, co-manager with John Millar on the Martin Currie Japan fund, says yen weakness and valuation are two possible explanations for the poor performance of the Japanese stockmarket. He says Japan “compared with other markets…does not look cheap, particularly if we look at Asia, which is only just starting to be re-rated”.

He adds it is “not surprising” that Asian markets have outpaced Japan. However, Thomas argues there is sufficient scope for Japanese firms to deliver “positive earnings surprises” and hence justify the Japanese market’s current valuation.