At MoneyWeek, we’ve long been fans of Japan. Three years ago, after a decade of deflation and a brutal bear market in equities, we thought we spotted a bull market in the making. Since then, the market has risen over 100%. But suddenly things don’t look so good. Since we last did a cover on Japan in April, the Nikkei has fallen 4.5%. So what are investors to think? We asked strategist Russell Napier and Japan old hand James Ferguson to take a look at the situation.
Their conclusions? The bad news is that they disagree over the short term – Russell thinks the end of deflation means the bull market is here to stay, while James thinks growth has stalled for now and is taking his money off the table. But the good news is that if they look at it over the long term, they agree absolutely: Japanese equities offer the opportunity of a lifetime.
Japan: the opportunity of a lifetime
Russell Napier
Back in the 1980s Japanese investors saw the equity market as a one-way bet. They bought shares convinced prices would always rise (despite the fact that the market was on a p/e of around 70 times) and that it would make them rich. This turned out to be something of a delusion. Nothing moves in a straight line forever and Japanese equities are no exception: the market soon collapsed. But I’m not sure the attitude of the investors of the 1980s was any more delusional than their attitude now. Today, Japan’s investors are again convinced investing in equities is a one-way bet. However, this time round they can find nothing at all attractive about the equity market. They hate it. So instead of buying equities, they’re buying bonds (notably Japanese government bonds, or JGBs) in the belief that doing so will keep their money safe.
I think they’re making a big mistake: history suggests that far from being a money-losing proposition, the Japanese equity market currently represents the kind of investment opportunity most of us will only see once or twice in a lifetime.
I spent much of 2004 and 2005 writing a book on the history of Wall Street. Anatomy of The Bear: Lessons From Wall Street’s Four Great Bottoms focuses on the four occasions in the 20th century when investors could have made the most from investing in equities – 1921, 1932, 1949 and 1982. The aim of the book was to discover what the four periods had in common. There turned out to be one crucial factor in creating the environments in which equities became ridiculously cheap. That factor was deflation, and it is this that explains why I think Japanese equities will do so well from now on.
In deflationary times, government bond investors tend to profit in absolute terms: bond prices rise as interest rates fall (see page 44), but the fixed-cash payout on bonds buys ever greater amounts of goods as retail prices fall. Equity investors get a rougher ride. Corporate earnings suffer as the prices at which firms can sell their goods decline, while many of their business costs remain fixed. The result is often a collapse in dividend payments and an investing nation that starts to shun stocks. America in 1921 is a classic example: deflation had hit 20%, bond investors were profiting nicely and equity investors were heading for the exits fast. Equities, equities can become very cheap in such an environment, and in the aftermath, they can make investors a great deal of money.
So what causes the turnaround? What makes stock prices forced to real lows by deflation suddenly change direction? The answer is inflation.The attractiveness of fixed-interest securities disappears as deflation ends. Fixed payments have less allure when prices are rising and hence the purchasing power of those payments is falling: yields on bonds usually reach such low levels in deflationary episodes that even mild levels of inflation can have powerful impacts on their buying power.
This is what is happening in Japan. After 14 years of nasty deflation, prices are finally turning around. In June 2003, the yield on the ten-year benchmark bond had neared 0.40%. Such a yield might have been attractive in 2003 – Japan had experienced an annual deflation rate of 1.6% in February 2002. But annual inflation today is running at more like 0.6%. Not surprisingly, the yield on the benchmark bond has risen and it is now approaching 2%. Anyone who bought the bond in 2003 and still has it now hasn’t found security in fixed interest. Instead, they’ve lost money, which might make them think twice about investing in bonds again. This is exactly what happened in the US from 1949 to 1968. Investors had shunned equities in the wake of the depression of the 1930s and the dangerous post-war deflation. Then they slowly realised that the post-war era came replete with inflation and equities would provide better risk-adjusted returns than bonds. So they started to pour out of bonds into equities: the yield on long-term government bonds more than doubled (ie, prices fell), but at the same time the Dow Jones rose almost 700%. My bet is that Japanese investors are in for a similar period of slow capitulation as the persistence of inflation undermines the case for holding bonds and pushes them back into the equity market.
So how far might the Japanese market go?
The death of deflation, or at least the threat of deflation, proved a profitable time to buy US equities (in the 97 months after the low in 1921, stocks rose 491%, for example, and in the 208 months after 1982, they rose 1,408%). There is no reason why it shouldn’t be just the same in Japan. The chart of the cyclically adjusted p/e shows that a significant proportion of the returns in the US derived from higher valuations. Whereas US equities have traded near, or below, ten times cyclically adjusted earnings at the start of the bull market, they exceed 20 times earnings by the end of the bull market. On average, two-thirds of the total return in these four bull markets is accounted for by rises in valuation, and only one third by rising earnings.
This leads to two important conclusions for the bull market in Japanese equities. The first is that earnings growth does not have to be spectacular to provide excellent returns – over the average 12-year US equity bull market (post deflation), annual growth in cyclically adjusted earnings was less than 8% a year. The second is that as domestic investors come to their senses, the p/e of Japanese equities could rise to a level just as high as that of the late 1980s. This may sound absurd, but it is perfectly plausible. Equities account for less than 8% of the total financial assets of Japanese households (the equivalent number in the US is 30%). Japanese private pension funds have only a quarter of their funds committed to equities (similar US institutions have committed almost 65%). The Japanese public pension schemes still have less than 10% of funds in equities (60% in the US) and Japanese households have accumulated vast savings, all of which need a home.
It wouldn’t take much of a shift of all this money back into the equity market once again to suspend such gravitational pulls in Japan. Based on the analysis in my book, it seems to me that a great buying opportunity now exists in Japan.
Time to take a break from Japan
James Ferguson
In many respects, Japan still looks like something of a golden opportunity for investors. After more than 15 years of pain – a property crash, a nasty equity bear market, deflation and, finally, a decade-long credit crunch – things seem to be looking up. Profit margins have hit new records levels, exports are now booming, and domestically, bank lending is growing for the first time since 1996.
There’s no doubt that Japan is back. So why isn’t the equity market rising? Because markets don’t just follow the big structural shifts (from deflation back to rising prices, from credit crunch back to recovery, for example); they also react to the much shorter-term influence of the usual economic cycles – and in terms of the cycle, now is a time to be more cautious than optimistic.
Take profit margins. Never since the war have Japanese pre-tax profits been so high. At just over 4%, they may not seem that high to you or me, but for Japan that’s high. And there’s the problem. Any time in the past 45 years when margins have got above 3.5%, they have fairly swiftly dived again, sometimes as much as halving. The nature of economic cycles is that when you’re near the top, the seeds of your downfall have already been sown: when things are the best ever, there’s usually little room left for further growth. This may be as good as it gets for companies this time around.
Many economists have been arguing this week, as they have for months now, that the growth outlook for Japan is very strong. The IMF just released an optimistic forecast for global demand growth next year and the Bank of Japan’s economic survey, the Tankan, currently paints a very rosy picture. But I’m not convinced. The problem is that far too many people are looking at the currently good economic data – on employment, on production and on consumption – and thinking that they tell us the outlook is good when they don’t. All these economic indicators are what we call coincident, or lagging, indicators – they tell us things have been good, not that they will be.
In order to forecast where the economy could go next, we need to look at
so-called leading indicators (such as confidence measures, order trends and markets). Some markets, such as those in Japanese government bonds (JGBs), metals and, most recently, in oil, are giving mixed signals – especially about the strength of future demand. Overall, Japan’s leading economic indicator (LEI), which is made up of 12 different components, is pointing to significantly slower growth ahead.
If the LEI is giving a correct signal, then over the next six months or so, industrial production will soon peak and will turn negative by about March/April time. Once the economy loses momentum, it will be tough to prevent profit margins falling. Corporate capital expenditure growth tends to turn negative when manufacturing operating profit margins (OPMs) drop below about 3.75% (see chart, right). And manufacturing OPMs themselves drop below 3.75% when industrial production growth turns negative. Everything in the cycle is tied to everything else. Strong growth generates higher profit margins, which in turn feed into higher capital investment. But once the growth cycle turns south, for whatever reason, profit margins tighten and investment gets cut back. The chances of everything turning down are always highest near previous peaks.
Another way to look at this is to consider the two sectors that have driven the rise in the Japanese market over the last few years – exports and banks. The situation isn’t good for either of them. Exports are predominantly dependent on the US and China. With US leading indicators also pointing towards a sharp slowdown in economic activity (as I discussed last week) and Chinese authorities clamping down hard on the bank credit that is financing their investment drive, the supports are fast being removed.
That’s not good for Japan’s export stocks. So what of the banks? On the one hand, they look pretty good. Only a few years ago they were all close to insolvency, but now, as Japan moves out of its credit crunch (ie, the banks are able to lend out money again and hence to make money from doing so), they are flush enough to pay back the government bail-outs they needed then. But can this happy situation continue?
My guess is that it probably can’t. Now that people can borrow money in Japan again, they have done – there has been a huge surge in real-estate-related loans in particular. Unfortunately, this has made Japan’s central bankers feel a bit nervous and they have therefore started to withdraw what they considered excess liquidity, something that has shown up as a drop in the broad supply of money. Real Broad Money growth (Broad Money minus CPI) has a record of telling us what will happen to real GDP three to six months later. And right now, if you look at the numbers and the charts, they suggest that, based on the historical relationship, Broad Money is leading real GDP towards negative (–1%) territory by the first quarter of 2007.
In this, it would agree – both timing and magnitude-wise – with what the Japanese LEI is telling us. It also tallies with the US LEI and housing indices, which are leading growth south there too. One immediate consequence of this is that loan growth in Japan is slowing on a year-on-year basis and will probably head towards zero by March of next year. With the economy growing too slowly, the banks can’t accelerate new loan growth (and make money from it).
Indeed, while loan growth looked like it was on a great trajectory at the beginning of the year, by the end of September, loans outstanding were just 0.4% up on 31 December last year. Even worse, most of the loan growth last year was during the second half and outstanding loans today are still below last March’s peak. The bank sector has run out of momentum.
To my mind, this all adds up to bad news for the short and the medium term. Yes, Japan has been recovering and yes, profit margins are up at new record highs. But economic growth still depends very heavily on industry, and the swing factor there is exports. Unfortunately, the overseas situation, especially the threat the US housing collapse offers to debt-financed consumption (and hence economic growth), combined with Japan’s own leading indicators turning down, implies that growth may have peaked. And history shows that if growth slows, margins tighten and earnings drop. At the same time, the domestic story – and especially the long-awaited recovery in bank lending – has run out of steam.
Without bank lending moving firmly back into positive territory, even the real-estate recovery story, which should be a given (Japanese real estate is stupidly cheap), may hit a speed-bump. The fact is that however good your structural story may be, if you hit a cyclical downturn, the cycle always overrides the structural story in the near term.
It’s too early to be absolutely certain that the cycle is about to downturn. If America can somehow break its circle of death (house prices determine mortgage equity withdrawal, which provides the debt finance for consumption, which accounts for nearly 70% of GDP), then the rest of the world, including Japan, probably can too. But leading indicators are called that for a reason. They are tried and trusted (if not absolutely proven) indicators that are supposed to give you fair warning of trouble to come when every other measure is still looking rosy. A bad LEI is a bit like a large hole in the side of your ship; it doesn’t mean you are definitely going to sink, but it certainly isn’t good news either. All in all, it seems to me that this is a better time to take some risk off the table than to bet the ranch. I’m still keen on Japan for the long term, but for now I’m happy to take a break from it.
Wil Koizuni’s successor succeed?
One of the bull points for Japan over the last few years has been its young-at-heart, Elvis-obsessed prime minister, Junichiro Koizumi. He may not actually have implemented much in the way of reform, but at least he’s talked a good game. But what of his successor, Shinzo Abe? So far, there’s little to complain about.
He has asserted himself as a no-nonsense nationalist and an international statesman, but this image has been softened by his wife. Stylish and fond of flamenco and Korean soap operas, one-time radio DJ Akie Abe has endeared herself to the Japanese public by speaking candidly about her life with Japan’s youngest-ever prime minister. She refers to her husband as ‘Shin-chan’, an affectionate nickname popular with teenagers, and has revealed that he likes aromatherapy candles and US TV show Lost. She hasn’t said much about his attitude to economic reform as yet, but Abe is known at least to have supported Koizumi’s recent market reforms. He argued strongly against the monetary tightening that’s recently hit bank lending (see main story) and appears reluctant to embrace the tax rises others think Japan needs to repair its fiscal health – all good signs so far.