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Japan’s Recovery: More than Just a Flash in the Pan

By Darrel Whitten

TOKYO (KWR) Over the past year, Japan's Nikkei 225 index has regained a degree of vitality not seen for most of the "Heisei Malaise". What is the Japanese stock market trying to tell us? We believe that Japan's economy and stock market is at a juncture similar to that experienced in the US in the early 1980s, as the US economy and stock market was emerging from a decade-long malaise.

The first major change of foreign investor sentiment was the replacement of BOJ Governor Hayami with the new Governor Fukui. Mr. Fukui gave the impression to both the Japanese government and investors that he would be much more flexible regarding "unconventional" monetary policy. Mr. Fukui gave foreign investors the impression that the BOJ was about to embark on a more aggressive reflation stance.

Then came the de facto nationalization of Resona Bank by the government in May, 2003. This was taken as a resolute attempt by Japan's banking regulators to; a) continue pressuring the banks to clean up their NPL (non-performing loan) problems, and, b) at the same time ensure a "soft landing" in terms of financial sector fragility. It marked a major turning point in the growing fear among domestic politicians and investors that Heizo Takenaka, appointed as the new Financial Services Agency Minister in September 2002, might force a "hard landing" solution on the nation's banks that could jeopardize any chance of an economic recovery. These fears proved unfounded. The grim forecasts of a possible collapse of the Japanese financial system made regularly since Japan nearly experienced a financial meltdown in late 1997 have rapidly lost their shock value as the signs of a revitalization of the banking sector become unmistakable. The program to reduce NPLs at the major banks by half by March 2005 now looks achievable.

Many domestic critics and investors claim that Prime Minister Koizumi has been long on talk but short on execution as regards his reform initiatives. However, PM Koizumi's self-state first priority for reform was the definite and final disposal of bank NPLs and a stabilization of Japan's financial system. With the major banks now expected to meet their NPL ratio targets by the stated cut-off date, the Koizumi Administration appears well on its way toward achieving the stated number one priority of its original reform program.

Japan's current economic recovery was first dismissed as yet another transitory phenomenon that was based mainly on exports. But as 2004 has progressed, there is increasing evidence of a deepening of the recovery. Third quarter FY03 (October-December) GDP growth was a big surprise, clocking in at 7% annualized growth rates, and the Bank of Japan's December Tankan survey was already indicating better-than-expected business conditions, with Japanese businesses being more optimistic than they have been in six-and-a-half years.

Industrial production has been rising for over a year, and has recently accelerated to the 5% YoY level. Meanwhile, inventory levels continue to decline. Machinery order growth by the last quarter of calendar 2003 had accelerated to high two-digit levels. There are also signs of life among Japan's beleaguered consumers. The BOJ's integrated retail sales indicator jumped by 2.2% over the previous month in January, and has been in a mild recovery since last fall. Real household expenditures during January were also up 1.3% YoY.

Corporate profits are in solid recovery. The MOF's survey of incorporated enterprises indicates that aggregate ordinary corporate profits for the October-December period of 2003 grew by 16.9% YoY-after bottoming in terms of YoY change rates in late 2001 on declines approaching 40% YoY.
Moreover, the cyclical recovery is being aided by significant improvement in the earnings structure of companies. Operating profit and ordinary profit margins for the large companies in the MOF survey of incorporated enterprises are nearing levels not seen since the beginning of the Heisei Malaise, as companies have reduced debt, trimmed employment ranks, sold off or closed unprofitable businesses, and moved operations overseas.

While Japanese companies are still reluctant to increase hiring, there is evidence that investment in domestic plant, equipment and factory sites is recovering. In 2003, the number of sites purchased for new factory construction increased for the first time in three years to over 1,000 cases, according to METI. In other words, the "hollowing-out" trend may be reversing.

A Nikkei survey of over 1,600 listed companies reporting in March indicates that listed companies in all industrial sectors will mark a combined 21% gain in consolidated pretax profit for the current year through March 31, the first record high in three years. The survey also indicates aggregate pretax profit will rise another 14% in fiscal 2004, for the third consecutive year of gains.

All the above is evidence that the economic recovery is deepening and will be more pervasive than any mere cyclical up-tick in the Heisei Malaise so far. Indeed, we are convinced that Japan has turned the "big corner" and is now well on it's way to escaping the Heisei Malaise. The key will be "continuing to stay the course" to ensure that the recovery deepens further, and eventually leads to improved medium-term growth potential for Japan's economy.

Free operating cash flow for large firms, the real value driver behind stock prices, first turned positive in late 1993. It has remained positive throughout the Heisei Malaise. However, balance sheet and financial sector risk has heretofore more than offset this free cash flow - until the regulators and the banking sector began to get their arms around the NPL problem.

As the negative cycle of falling prices (deflation), depreciating asset values and growing NPLs begins to reverse, bankruptcy risk and financial sector fragility improves, allowing both financial institutions and investors to become less risk adverse. The "bankruptcy" and "growth" discounts disappear, and domestic investors are able to assume a higher risk profile, i.e., to begin shifting assets from bonds and bank deposits into the stock market.

When this happens, domestic institutional investors could well become the driving force of the next big upleg in the Japanese stock market, as they shift assets from an overwhelming preference for bonds and fixed income into stocks. Once begun, the secular shift into stocks by domestic institutions could well continue driving Japan's stock market for the next several years.

Over the short-term, it could prove problematic for the Bank of Japan should end-of-deflation expectations run too far ahead of actual fundamentals, as it could instigate a "buyers strike" in the bond market, and sharply push up bond yields at a time when the government would rather keep interest rates as low as possible to facilitate increased deficit funding bond issues.

With even the BOJ finding it difficult to suppress their optimism about the current recovery, however, the inevitable shifting of monetary policy gears could cause an interim correction in the stock market. However, we would view this as mainly a transitory impediment, as Japan's economy and financial markets begin to return to normalcy.