The Sun Rises?

The Japanese economy enjoyed rampant growth in the 1970‘s and 1980’s. The combination of very high levels of business investment and a well educated and compliant workforce led to strong profits growth. Success bred success because as Japanese industry became progressively more profitable, Japanese consumers became ever more confident and perpetuated the economic boom by spending.

However, a bubble was developing in real estate and equity markets. By 1989, Tokyo property was comfortably the most expensive in the world with some apartments being sold for around £10,000 per square foot. To put this in context, even now prime apartments in Mayfair cost ‘only’ around £2,500 per square foot. The Japanese stock market kept rising also so that on 29th December 1989 the Nikkei 250 share index peaked at 38,915. The problem was that valuations did not reflect reality and were driven simply by the excess liquidity that occurs in economies that binge on cheap credit. Money was too freely available and banks were guilty of granting loans that had no realistic prospect of being repaid. It is rather depressing that Western politicians and bankers did not learn from this rather obvious lesson.

A sharp decline followed by a steady decline in asset values followed, particularly in real estate. The position was exacerbated by the extent of property backed bank lending and how this was subsequently dealt with. Both government and regulators encouraged banks not to write off bad loans and not to recognise these deficits fully on their balance sheets. Base interest rates were slashed to zero, which allowed a broadly insolvent Japanese banking sector to stagger onwards and zombie businesses to survive only because their debt servicing costs had been slashed.

Asset values continued to fall for around 12 years. The Nikkei 250 share index bottomed out at 7,603 in April 2003, representing an 80% fall over 13 years. It is rather shocking that Japan’s nominal GDP is no greater now than it was in 1991. Political and bureaucratic timidity has followed until recently, locking Japan into a cycle of deflation. This has been selfperpetuating because an economy is less likely to grow if consumers are reluctant to spend. Why buy something now if you know it will be cheaper tomorrow?

In 2010 China overtook Japan to become the world’s second largest economy after the US. China is becoming more assertive and this has been an important stimulus for change in Japan. Finally, it looks like there is a meaningful strategy to shake Japan out of its economic malaise.

Shinzo Abe, Japan’s new Prime Minister has resolved to revitalise Japan and has installed a like minded governor of the Bank of Japan, which has made a commitment to eliminate deflation. The method chosen follows, in spirit, the approach of the US Federal Reserve and to an extent, the Bank of England.

However, what is different is the scale of this stimulus, which dwarfs what has occurred in the US and UK when measured relative to the size of the economy. The monetary base is to be doubled over a two year period and the central bank’s balance sheet is to be increased at the rate of 1% of GDP per month, which is twice the rate currently pursued by the US Federal Reserve. Furthermore, a target has been set to create inflation and stabilise it at 2% per annum.

There is no doubt that this is a brave strategy but it is not without risk. Japanese government debt is already very high at 240% of GDP. Compare this to the UK where government debt is a ‘mere’ 90% of GDP. If the cost of servicing Japanese government debt were to spiral default might become inevitable.

Nevertheless, the early signs are encouraging. GDP growth of 0.9% in the first quarter of 2013 is impressive. Annualised to 3.5% this represents one of the stronger economic performances in the developed world.

The Japanese stock market has rallied strongly. However, I can’t help feeling that later investors are over-paying. Share prices have risen too far too quickly because investors have been carried on a tide of optimism. There is no guarantee the new strategy will work and the downside if it does not could be significant.

It is important to bear in mind (see chart) that Japanese share prices are, once dividends and currency fluctuation are stripped out, only a third of the value approximately 23 years ago. It is currently trading at around 12,900.

At present, the price/earnings ratio (P/E) for the companies that comprise the Nikkei 250 share index is 23. This compares with a P/E of around 16 for both the FTSE100 and Dow Jones. In other words, profits growth of Japanese companies will need to very comfortably outstrip profits growth of UK and US companies in order to deliver a better return over time. The earnings of Japanese companies will benefit from a devalued Yen because currency earned overseas will convert to more Yen when repatriated. Also, the products of Japanese exporters will become more competitively priced in other currencies. Superior profits growth for Japanese companies is therefore a possibility.

To conclude, a modest exposure to Japanese equities will be a good diversifier for a longer term investor with a balanced approach to risk. However, careful scrutiny is required to select the right funds and investors should recognise that Japan is far from a one-way bet. It is therefore a good idea to seek advice.