Encouraged by
positive reports, foreign observers are becoming
far more positive about Japan's economic
prospects. The latest data includes noteworthy
improvements in employment, land prices, consumer
and industrial confidence as well as spending,
indicating that Japan's economy is gaining speed
and may be entering a new phase of sustained
recovery.
Regulatory changes have played
an important part in laying the foundation for
these developments. The victory of the ruling
coalition also puts an end to the political
uncertainty and reaffirms Japan's commitment to
reforms. As it is, investors have been
accelerating their allocation
of funds into Japan-related investments. Many
believe this is because Prime Minister Junichiro
Koizumi's decision to go to the polls has served
to focus the spotlight on those who have been
resisting reforms, and no matter who won the
elections, the entry of non-traditional pro-reform
candidates into the political arena would have
major consequences.
There are certainly
risks to investing in Japan, and improvement is
not likely to be linear in nature. Nevertheless,
improving fundamentals, favorable valuations, and
ongoing corporate rationalization suggests both
portfolio and corporate investors would be wise to
pay more attention to Japanese business and
financial markets.
The Japanese economy
continued to yield positive economic news on
multiple fronts during the second quarter of 2005.
Bankruptcies decreased 9% year-on-year and
unemployment fell as well. Japanese companies also
sustained their efforts to upgrade plant and
equipment, boosting investment spending by 2.2%
over the April-June quarter. Although Japan's real
GDP (gross domestic product) rose only by a modest
0.3% in the April-June quarter (a 1.1% annual
rate), a look at the broader numbers led BNP
Paribas economist Yoshimasa Maruyama to state,
"The numbers are very strong."
Supporting
this assessment, government statistics reported
that Japanese economic output rose a seasonally
adjusted 1.5 % in June. Electronic components
represented an important component of this
increase and suggest, in the view of Credit Suisse
First Boston (CSFB), that Japan's IT sector is
making progress in reducing its inventories.
Machinery orders are a standout, surging by 11% in
June from a month earlier. June's Tankan survey
also showed a significant rise in business
confidence. Commenting on the survey, CSFB
economist Yukari Sato opined in a Financial Times
article that the survey results were "an economic
turning point for Japan".
There was more
behind this optimism, however, than the Tankan
survey. Japanese exports in June, for example,
rose for the first time in three months, reaching
a record high of $48 billion. This news was
complemented by a rise in Japanese employment and
retail sales figures, which are now at their
highest levels since 1997-1998. Jesper Koll, chief
economist at Merrill Lynch Japan, asserted in the
Financial Times article, "the conditions for a
self-sustaining domestic demand-led
non-inflationary growth path are better than ever.
It's never been as good as this."
On the
employment front, Japan's jobless rate fell by
almost 300,000, to its lowest level in seven
years. Other statistics hint that Japan's
improving labor situation is fueling growth and a
rise in full-time positions as well as wage
increases. Data shows average earnings in June
increasing 1.1% over the previous year. Positive
trends in land prices in certain areas of Japan
also indicate a trend toward greater confidence on
the part of Japanese consumers.
Equally
important, there are signs that Japanese citizens
are beginning to draw money from their bank
accounts to invest in the stock market. This
suggests Japanese households are becoming less
risk adverse. Domestic consumption, which many
view as the "missing link" to a sustainable
recovery in Japan, also appears to be on more
solid footing. Progress, however, has not been
linear. For example, after a 2.7% year-on-year
rise in May - following even stronger April
results - private consumption consolidated to a
more modest year-on-year rise of 0.1% in June.
Nevertheless, Takuji Aida, an economist at
Barclays Capital, said: "Japanese domestic demand
is much stronger than the markets expects."
Another factor troubling Japan in recent
years is the phenomenon of deflation. Deflation
limits domestic spending as it reinforces a
reluctance to consume. While signs of deflation
continue to exist in Japan, current data shows it
has begun to ease or even reverse itself in
certain areas. Barclay's Capital, for instance,
argued that data showing a rise in clothing prices
"where deflationary pressure had previously been
strongest, is symbolic of the easing deflation in
the Japanese economy". Other commentators have
pointed to the decline of "100 Yen" stores
(analogous to 99 cent stores in the US) as
evidence of the moderation of deflation. Indeed,
in the business sector, prices are actually
increasing.
Restructuring &
reforms Another factor that bodes well for
Japan is continuing efforts by its government to
create a positive environment for restructuring,
reform, and foreign investment. Measures initiated
since the adoption of the Action Plan for Economic
and Structural Reform almost 10 years ago include
tax reforms, changes to the Anti-Monopoly Act, and
the development of new policies vis-a-vis hostile
takeovers. These steps have been well received by
foreign governments, industry associations and
investors, and are reflective of Japan's
continuing desire to encourage increases in
foreign investment through mergers, joint
ventures, and even hostile takeovers - a practice
considered virtually impossible in Japan even a
year ago. Initiatives to support FDI (foreign
direct investment) are also likely to derive
additional energy in future as Japanese and
foreign shareholders are increasingly willing, and
empowered, to exert their influence on management
to gain maximum efficiencies and value.
Corporations on the move The corporate
sector in Japan has not been idle in the face of
numerous government-led policy and reform
initiatives. Changes in
competition and tax laws,
coupled with market pressures, have induced
consolidation in the steel, paper/pulp, and
distribution sectors. Furthermore, Japanese firms
have begun to unwind cross-shareholdings. As the
Japanese corporate model has changed, firms have
become more willing and eager to embrace foreign
investment.
These
changes have led to a surge in M&A (merger and
acquisition) activity. Japanese firms are now
utilizing M&A techniques to restructure and
enhance the competitiveness of their operations.
At the same time, M&A activity between
Japanese and foreign firms has also risen
significantly since the early 1990s, when it was
virtually nonexistent - yet still accounts for
only a relatively small amount of total activity.
As foreign entities increase their commitment to
Japan, and Japanese managers and employees become
increasingly comfortable operating under foreign
ownership, cross-border M&A is likely to
represent a progressively larger share of total
activity.
Individual Japanese firms are
also introducing other measures to achieve
efficiencies and to control costs. Sanyo, for
example, a major electronics firm, recently
announced plans to initiate a comprehensive
restructuring, involving a 15% workforce
reduction. Sanyo's new CEO, Tomoyo Nonaka, the
first woman ever to head a leading Japanese
electronics group, noted in a Financial Times
article titled "Sanyo wields axe to achieve
turnaround" that "there will be no taboos" in the
restructuring program. For its part, Sony
appointed a foreigner, Howard Stringer, as chief
executive, in an effort to restore the firm's role
as an innovative global powerhouse. Restructurings and consolidations are a
hard reality of business, even where so-called
"new-economy companies" are concerned. For
instance, in the game software sector, Sega has
merged with Sammy, Bandai with Namco, and Takara
with Tomy. Japanese businesses continue to invest,
to enhance their competitiveness and to prepare
them for new opportunities. During the first
quarter of 2005, Japanese manufacturers increased
their investment by approximately 8% while other
Japanese firms boosted their investment by roughly
7%. According to GaveKal Research, what may be
most noteworthy about this data is that Japanese
firms are investing to "churn out profits", that
is, "without lowering the returns on invested
capital".
Higher levels of corporate
investment are attributable, to a large extent, to
the double-digit increases in profitability
experienced across both the manufacturing and
non-manufacturing industries. This is particularly
true among SMEs (small and medium enterprises).
Japanese manufacturing SMEs recorded a dramatic
42% increase in profits in the first quarter of
2005 - compared to the first quarter of 2004.
A third area where there are positive
developments are actions taken by Japanese
managers to focus on shareholder value. This is
manifest in the rising number of dividend payout
increases and share buybacks announced in recent
years. Japanese companies are also according more
importance to communicating with outside
investors, sometimes hiring investor relations
firms to connect with shareholders.
Many analysts believe Japan's
changing corporate environment, coupled with
supportive policy moves, is opening up a range of
new opportunities. UK-based Hermes, for example,
has partnered with Nissay Asset Management of
Japan (Namco) to create one of many new funds
seeking to foster change on under-performing
companies. Wataru Tanaka, the president of Namco,
told the Financial Times, "The time is right to
introduce a new investment philosophy based on
encouraging shareholder friendly management."
Aside from market forces, already enacted
government policies as well as policies now being
developed will serve to sustain and enhance the
transformations now taking hold. More
specifically, changes in disclosure requirements,
accounting standards, and the tax code will
continue to generate incentives for Japanese firms
to pursue efficiencies, to embrace domestic and
foreign partners, and to invest at home and
abroad.
Investors increase
involvement Japanese stock market indices
hit four-year highs in late August, with both the
Nikkei-225 and Topix reaching levels not seen
since April 2001. This strength had much to do
with inflows of foreign funds, which had been
positive for five consecutive weeks, and totaled
nearly US$450 million in the week ending August 17
alone. The strengthening case for investing in
Japan is linked to numerous factors, including
improvements in consumer demand and corporate
spending, corporate profitability, and a newfound
emphasis on stockholders, and supportive
government policies. In addition, rising
confidence in, and coverage of, Japanese economic
trends, is helping to attract a wider group of
investors, who are now coming to recognize the
potential for diversification and the fact that
many Japanese firms possess more favorable stock
market valuations than their competitors in
European and US markets.
Despite the surge
into Japanese equities that has been seen, Hideki
Takayama, chief investment officer at State Street
Global Advisors, stated in remarks to the Wall
Street Journal, "It is not too late" to invest.
For his part, Youssef Affany, head of investment
counseling at Citigroup Private Bank observed,
"Japan is about to realize its longer-term growth
possibilities." Technically oriented investors
also see positive signs in the surge of Japanese
indices through resistance levels. As reported in
Barron's, even Japan bears seem to be embracing
the view that the country has reached a turning
point with Dr Carl Weinberg of High Frequency
Economics, a long-time pessimist, expressing hope
about Japan's economic prospects. Corporate and
other direct investors also seem to be more
optimistic about the prospects of Japan and
Japanese corporations. According to government
data released in June, foreign direct investment
over the 12-month fiscal year ending last March
was approximately $36 billion, double the previous
12-month period. Incoming FDI was substantial
enough to outweigh outgoing FDI for the first time
since Japan started keeping records in 1950.
Fundamentals likely to
improve While fund managers such as Hans
Goetti, of Citigroup Private Bank in Singapore,
maintains a thoroughly optimistic outlook, stating
in a recent Bloomberg interview that "Japan's
story is one of the most compelling you can find
globally", all investments are not without risk
and uncertainty. For one thing, the rush by many
financial investors to redress their underweight
allocation of funds to Japan may lead to some
consolidation in coming months. This should not be
surprising given the Nikkei 225 index rose over 5%
in the first 12 trading days since lower house
elections were called on August 9.
Another
potentially salient risk is the impact of
increasing oil prices as well as the potential for
economic weakness in China, Europe or the United
States. Despite increasing signs of domestic
strength, these markets absorb large quantities of
Japanese exports. Therefore, weakness in these
markets could have major implications in terms of
economic activity in Japan.
On the bright
side, Asian integration and Japan's increasing
ties with India and Southeast Asia will make it
somewhat less vulnerable to the vagaries of the
American and European economies. On the other
hand, should US economic growth remain stable,
this is likely to create additional opportunities
and remove, in the words of Richard Jerram,
economist at Macquarie Research, "one risk that
could disrupt the domestic recovery" in Japan.
While analysts and investors need to incorporate
risk and volatility into their investment plans,
they also need to be cognizant of the continuing
improvement in Japan's underlying fundamentals.
Rising output growth, consumer spending,
increasing capital investment, as well as major
changes in Japanese corporate strategies are all
leading to greater interest and opportunities for
business and investors. Finally, it should be
emphasized that many Japanese companies are now
valued at what Goldman Sachs recently termed
"historical lows". This allows for substantial
appreciation both within select Japanese equities
as well as fixed investment into companies, real
estate, greenfield projects and many other areas
and sectors.
Compiled by the Japan
External Trade Organization (JETRO) in New York in
cooperation with KWR International Inc.
competition and tax laws,
coupled with market pressures, have induced
consolidation in the steel, paper/pulp, and
distribution sectors. Furthermore, Japanese firms
have begun to unwind cross-shareholdings. As the
Japanese corporate model has changed, firms have
become more willing and eager to embrace foreign
investment. 
