International | Dec 07 2007
By Greg Peel
If it’s not one thing it’s another in the Japanese stock market. Earthquakes, political scandals, and controversial regulatory initiatives are amongst some of the factors which have dogged Japanese equity investment over the years, not to mention the country’s seemingly perennial state of deflation.
Things were looking very healthy in 2006 and analysts were beginning to see a light at the end of the tunnel for Japan, but then along came the “Livedoor Scandal”. This involved one of the most successful and popular internet start-up companies in Japan – one which had advanced many multiples in value – being found out as fraudulent. To top things off, the day the news broke the Tokyo exchange had to shut its doors because it couldn’t cope with the sell orders, and global faith was lost.
The scandal took the wind out of Japan’s sails just when everyone else was in bull mode, although it managed to drag itself back up. It recovered just in time for the credit crunch to hit.
UBS Japan equity strategist Shoji Hirakawa believes, however, that the Topix could rise to over 1900 by mid-2008. The Topix is the broad market Japanese index, not to be confused with the narrower Nikkei 225. The Topix closed yesterday at 1539, so Hirakawa is backing at least a 23% rally in six months.
UBS’ “top-down recurring profit estimates” over the next three years are in the range of 5-9%, and the analysts expect margins to improve over that time, thus offsetting Japan’s decelerating sales growth. History has shown that the Topix tends to perform well when the US Fed begins an easing cycle, and that has now begun. The Fed has cut its funds rate by 75 basis points already, and UBS is forecasting a further 100 basis points of easing – to 3.5% – by mid next year. (At least another 25 points is likely next week).
US monetary easing should end the current global recession fears, steepen the yield curve and push Japanese bank stocks higher, suggests Hirakawa. GaveKal analysts suggested this week:
“One of our rules is to feel good about Japan when banks are outperforming; this is now happening.”
GaveKal notes that Japanese equities have been “extremely lacklustre” since the Livedoor scandal, and long frustrated Japanese investors have been left wondering just what the catalyst might be to break the market out of its malaise. The political situation is deteriorating, the country is moving back into deflation yet again, global growth is decelerating and now the yen has been pushed higher on carry trade unwinding (making Japanese stocks more expensive for foreigners to buy).
At the moment, says GaveKal, Japan faces two major problems. Firstly, the regulators keep introducing extraordinary moves such as consumer finance controls and stricter building codes which continue to nip any recovery in the bud. Secondly, Japanese banks just don’t want to lend.
The last point is highlighted by a recent experience where GaveKal discovered a Japanese real estate investment trust (REIT), listed in Singapore, was unable to find local financing despite an extremely low gearing level of 45-65%. Instead, the REIT was forced to borrow at 2-3% from US investment banks (the Japanese cash rate is 0.5%) who then packaged up those loans (a la mortgages) and sold them back to – you guessed it – Japanese banks. Instead of investment in local property, the Japanese banks now had an investment in a potentially toxic collateralised loan obligation. This is less risky?
Maybe now that US banks are struggling to stay above their capital adequacy levels Japanese banks might start to think that lending locally is not such a bad idea after all, suggests GaveKal. And whaddya know – Japanese banks have been performing strongly in recent weeks while the rest of the world’s banks have been taking a hit.
Aside form the positive signal being sent by bank shares, UBS notes the Japanese equity market dividend yield is now above the yield on Japanese government bonds. Historically, notes Hirakawa, the Topix tends to rise by 50% in the year following this switch.
UBS advises overweighting Japanese financials, industrials and telcos, but steering clear of consumer staples, utilities and healthcare.
