Japan's new dawn
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We’ve all heard about a new dawn in Japan before, only to see the market slump. But this time, it really is different, and you should buy in now.
Last week, Japan’s Nikkei 225 index closed above the 12,000 level for the fifth time in 18 months. But unlike the previous occasions, this time the benchmark index didn’t dive straight back down again, something that has the market buzzing with excitement. Several other technical factors are interesting too. There is, for example, the fact that the index is moving on very high volume – around two billion shares a day – and that the upswing is very broadly based: the Topix Small-Cap index is at its highest level for eight years.
So, is Japan once again the land of the rising sun, or is this yet another false dawn? Every Roundtable that MoneyWeek has hosted over the last year has had the Japan specialists in almost universal agreement. On the one hand, Japan’s corporate sector looks like it’s turned the corner structurally – stocks are now cheap after 16 years of bear market and the real-estate-induced credit crunch is nearing resolution. But on the other hand, history shows economic cycles in Japan normally run out of steam after 12 to 18 months, something that implies we will see a new downturn again sometime this year.
Several times in the last decade and a half, this is exactly what has happened. Investors have got very excited as a global cyclical upswing has driven the market up 40% to 50% in the space of a year. But then, as in 1997-1998 and 2001, the cycle turned, taking the Nikkei down with it. The upswing has never yet turned out to be self-sustaining and there has been no end to the debilitating run of deflation in goods and land prices.
Is it different this timeThis time, it might be different: when the Governor of the Bank of Japan, Toshihiko Fukui, made his second-quarter statement on the state of the economy, he omitted the word “weak” for the first time in as long as anyone could remember. There’s even evidence that the Consumer Price Index (CPI) is rising for the first time since 1997. Unlike in the UK, where inflationary pressures are a bad thing, in Japan it’s just what is needed. Deflation causes householders to delay consumption, slowing economic growth. Worse, it keeps driving land prices down, depressing the value of loan collateral and forcing the banking system to constrain lending. Bank lending in Japan has been negative for the last seven years.
But that may be about to change. In July, Tokyo business-district property vacancy dropped to a three-year low of 4.76%. With no major new supply on the horizon, this has been enough to put a floor under rents, which are up year-on-year for the first time in a decade. With the banking sector claiming that bad debts accumulated over the nation’s “lost decade” have now been fully provisioned for, the scene is set for bank lending to grow again. With borrowing costs between 1% and 2% and property yields as high as 7% to 9%, a property boom could be just around the corner.
A self-sustaining cycle
So what else makes us think this time may be different? The fact that capital expenditure (capex) is on the rise. For months now, the economy has looked to be perched at the top of the cycle: the consumer still wasn’t spending and there appeared to be excess industrial capacity, so no one expected any capex to come through. There seemed to be no source of demand that could keep an economic upswing moving, hence the analyst consensus that the cycle would soon turn down.
That consensus was wrong. In fact, much of Japan’s industrial stock is now so old that it’s basically junk. It has to be replaced. Little wonder, then, that the latest capex figures have exceeded even optimistic expectations. On top of the rosy capex picture, the stronger-than-expected growth in consumer spending in the second quarter was just gravy. Leading indicators have also recovered sharply and now imply industrial production will be growing at 4% to 5% by year-end. With industrial production, consumption and capex all on the up, consensus GDP forecasts have been revised up to 2%, making 2005 likely to be the fourth straight year of economic expansion.
The expansion of profit margins
With the economy growing at a more sustainable rate, corporate sales can continue to grow, which should boost profit margins since firms’ costs are mostly fixed. But this will just be icing on the cake for Japanese firms. Since 1997, something extraordinary has been going on in the Japanese corporate sector: tired of waiting for the government bureaucrats, who orchestrated Japan’s post-war economic miracle, to deal with the post-1989 slump, firms started to take steps to boost their own profitability – whatever the environment.
Instead of passively relying on sales growth to boost profitability, Japan devoted itself to sustaining margins in the face of falling sales. In the 2001-2002 fall-out from the excesses of the technology, media and telecoms bubble, ‘old’ Japan could have expected pre-tax profit margins to have fallen well below 1.5% – as they did in 1993, for example. But in the ‘new-era’, Japan managed, with the brief exception of one quarter, to sustain margins of between 2.5% and 3%. With sales growth now running at 5% a year, pre-tax profit margins have been able to expand to above 4%, a post-war record. Yet until five days ago, the stockmarket was no higher than April of last year. Valuations are now at post-war lows, despite margins being at post-war highs.
How fast can it move?
But how much room is there for the market to move upwards fast? Well, if you compare it to other markets that have suffered major setbacks, it looks like there’s a lot of room. It took the Dow 25 years to regain its 1929 peak, but only six years to get back above the 35-year moving average. The commodity-heavy Australian All Ordinaries index took nine years to retrace what it had lost in the October 1987 crash and Korea’s Kospi index took 11 years to come back after its 1994 top. Yet 15 years after Japan’s bubble burst, the Nikkei is still just one third of its 29 December 1989 peak level. And the Nikkei is still lower than it was 20 years ago and 6% below its 35-year moving average. After 15 years!
This is extraordinary. It means that if a woman who was 25 years old in 1970 had put her pension into the stockmarket of the second-largest economy in the world every month since, today she would retire with less money than she’d put in, before fees and costs. Put another way, in real terms, you can buy Japan’s stockmarket today at the same price it traded at in the Christmas of 1983, about the time your latest graduate trainee was born. The Nikkei has lots of catching up to do.
What to buy
In the 1923 investment classic Reminiscences of a Stock Operator by Edwin Lefèvre, there’s an anecdote about a young investor angling for a tip from the wily old trader. But every time he asks what he should buy, the trader just replies “it’s a bull market” and walks away. What the frustrated young man didn’t understand was that in a bull market, just about everything will go up. So it is now with Japan. Luckily, there’s a very easy and cheap way into the market via exchange traded funds (EFTs). The ones issued by Daiwa and Nomura allow you to track either the Nikkei 225, or the wider Topix Index.
However, there are another two characteristics of bull markets that were also apparent in Lefèvre’s time. Firstly, bull markets attract a flow of funds like moths to a flame. Daily volumes in Tokyo are already over two billion shares, compared to less than 400 million for much of the late 1990s. This means bull markets aren’t usually all that clever. There’s no time for arduous research and prices can move before you’ve decided what to buy. Solution? Buy first, think later.
The fact that so much money flows into bull markets tends to favour larger capitalisation stocks. As luck would have it, over the last three years, small stocks have outperformed mid-sized stocks and mid-sized stocks have outperformed the wider index. The outstanding laggard group in Japan is the Topix Core 30, comprising the 30 most liquid, large capitalisation stocks. All the household names are there as well as the major financial and domestic demand plays. Even better, both Daiwa (stock code 1310) and Nomura (1311) have Japan-listed Core 30 ETFs – the Nomura one is the more liquid so probably the better one to go for.
Finally, for those who fancy a little more risk, there’s the Nomura Banks Sector ETF (1615). Japan’s 15-year slump has been caused by the fall in land values, which collapsed the value of loan collateral. Banks were thus unable to lend because their balance sheets were compromised and borrowers couldn’t get funds to take advantage of cheap property. Catch-22. If Japan is to come out of its hibernation, this negative spiral will have been broken and lending for property speculation will be back on the agenda. On top of this, the banks claim their bad loan woes are over and rising rates should expand margins. Believing them and buying in is a rather bigger, riskier call than buying an ETF on the whole market, but it might be a good one.
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