Weekly outlook

Look east to Japan

By Tom Stevenson, 17 June 2009

As the global rally continues, Japan is being overlooked by international investors. But for how much longer?

Japan is the world’s second largest economy, although you would be forgiven for having forgotten this. Plenty of column inches are devoted to the American top dog and China, at number three, gets its fair share of the headlines. Pundits regularly debate which of these two will do more to pull us out of the mire – the largest economy in the world or the biggest contributor to global GDP growth? Meanwhile, no one seems to be paying much attention to Tokyo. Perhaps that is because the Japanese economy looks like it has so much more to do before it can claim to be in recovery. In the midst of this global recession, US national output fell at an annualised rate of 5.7% in the first quarter of this year. Not great. Meanwhile, Chinese growth may have slowed but the economy still managed to expand by 6.1% over the same period. Japan, however, shrunk at an astounding 15.2% - the price of being hooked on exports when the whole world experiences a synchronised slowdown.

"Japan shrunk at an astounding 15.2% - the price of being hooked on exports when the whole world experiences a synchronised slowdown." Tom Stevenson

Perhaps it is also because investors never really regained their faith in Japanese shares after the long and painful bear market that dragged on through the 1990s and into the new century. Having peaked on the last day of 1989, it took until April 2003 for the Nikkei to find its feet again. It lost a staggering 80% in the meantime. A lot of fingers were badly burned.

But Japan is worth a look.

That 13-year bear market followed the bursting of Japan’s property bubble. That in turn crippled Japan’s banking sector. Interest rates hit zero percent. The Bank of Japan ended up buying toxic assets from the worst offenders in its banking sector and then forced them to recapitalise and clean up their balance sheets. Sound familiar?

The experience of Japan’s financial crisis has been the dark cloud hanging over the central bank response to the latest crisis. Quantitative easing, for all the hype that surrounded it when the US Fed and Bank of England started deploying it, was road tested in Japan in the 1990s.

Back then, the Bank of Japan and the Japanese government were criticised for being slow to act. They may have finally found innovative solutions to the problems they faced but a lot of the pain had already been felt before anything was done. This time around, the authorities have been fleeter of foot.

The Japanese government has enacted a fiscal stimulus package that is second only in size to that of China. The Bank of Japan is not only buying up government bonds, it is also taking corporate bonds onto its balance sheet. It has acknowledged early on that its economy is in deep trouble and is taking concerted steps to limit the damage. It is being just as aggressive in its attempts to reflate the economy as its contemporaries in the US, Europe and across the rest of Asia.

And yet, while investors regain their risk appetite and venture back into the stockmarket, they remain cautious towards Japan. Non-Japanese investors account for more than 50% of the trades on the Tokyo Stock Exchange and yet many continue to have very low exposure to the country. The average international portfolio had a 17% exposure to Japan when the rally kicked off in March. That is 7% less than the typical benchmark for such a portfolio and the largest underweight position since March 2002.

History shows us that Japan responds quickly to an improvement in the global economic situation. The recent upturn bodes well for Japanese equities. Indeed, the first three months of 2009 may have represented the bottom of the downturn; recent export and industrial production data highlighted the sharpest month-on-month increase in output in 56 years. Such positive news may be what’s needed to accelerate the return of international investors.

The Nikkei has rallied 38% from its low point in March. The fact that Japan is off pretty much every investor’s radar is one of the best indicators that there may be more to come.