Whilst the Bank of Japan has finally moved to push its country’s base rate up, by 0.25% to 0.25%, its first move in six years, financial market investors are eagerly champing at the bit and are anticipating more of the same over the next few months. Higher rates may act as something of a near-term headwind for the country’s equity market, the justification lies in ever strengthening data from the real economy.
Japan’s economic recovery: corporate debt under control
The latest news, culled from the Wall St. Journal is that companies are finally coming out of their shells and are beginning to hire more workers. Unemployment is already down to an eight year low and despite an influx of overseas workers, wage claims are expected to start rising. The Bank of Japan wants to give the Japanese economy every chance and has thus stated its desire to remain “behind the curve” (i.e. raising rates only when it is sufficiently comfortable that the economy is strong enough to withstand it and that inflation really is on a rising trend). The strength of the Japanese economy is something we alluded to back in our end-April Week in Preview.
After fifteen years of prevarication, the last five of which were, at least, characterised by monumental debt reduction, Japanese businesses have restored their balance sheets to health. Strangely, perhaps, the country’s big policy mistake in the mid 1980’s was aggressive debt liquidation!Japanese companies had over-expanded, owned too many assets, most of which carried too little intrinsic value. Purchases were financed with too much debt lent by incautious and under-capitalised banks. Although it took fifteen years to unwind the situation, Japanese companies are, by and
large, in as robust a financial state as at any time since the booming 1970’s.
Corporate debt levels are on a par with those of the United States and companies are now reporting significant profit and cash flow improvements, much of which has been directed towards further debt reduction instead of expansion. Inevitably this makes the consequences of Japan’s corporate recovery much less obviously visible.
Japan’s economic recovery: return to normality
Debts have been reduced and cash flow is strong. Japanese companies are paying higher dividends again and have discovered the benefits to be gained through outsourcing to China. Profit margins are expanding dramatically. The unfortunate side-effect of this is that it has, thus far, held back domestic investment, domestic employment, domestic consumption and domestic interest rates. In due course, Japanese companies will use cash to increase hiring. This should result in higher
consumer incomes, improved consumer psychology and higher consumer spending. Higher spending and improved balance sheets should make banks more amenable to lending, which should add a kicker to the upswing. All this should take place in a vibrant regional economy, reinforcing the strength of the recovery.
Japanese stocks, despite losing some earlier strength, are still discounting pretty thin earnings growth. The yen has, thus far, been held back by a Finance Ministry still obsessing about deflation and real bond yields are still being set by reference to the very easy policy conditions of the recent past. The transition from depression to normality (which we now find ourselves in) should change all that. Ultimately it should support equities through higher earnings growth, supporting the yen by eliminating the
need to fight deflation. Interest rates will rise, bond yields will rise (are rising) and the currency will rise…roughly in that order.
Whilst Koizumi’s bold political stance against cronyism has yet to bear real fruit, it has given him a huge personal mandate to continue the reform process and acted as a huge psychological catalyst which has reinforced the upswing and will doubtless mark him down in history, rightly or wrongly, as the man who, single-handedly, crafted the upturn.
By Jeremy Batstone, Director of Private Client Research at Charles Stanley