Key Themes for Japanese Equities in 2009
The yen’s recent rise has hurt the market by punishing exporters, which played an important part in pulling Japan out of the previous recession. However, the effect of the strong yen has been partially offset by lower raw material and import costs, and it has actually improved the situation for companies with overseas manufacturing bases and domestic-focused sales. Political pressure to intervene in the currency market is mounting as many large manufacturers and their suppliers are taking a double hit from the strong yen and the rapid contraction of the global economy. With past failures still fresh in its memory, the government is reluctant to commit itself again, but with interest rates already low and the absence of any other effective means of containing the currency, it might take actions beyond verbal intervention for the first time since 2003. However, the market seems to be taking the historical high of 79.5 JPY/USD as the peak value of the yen, so there is still scope for it to rise further. If the US economy continues to struggle, the yen could approach this level. The interaction of market forces and the possibility of government intervention is likely to keep the currency volatile throughout the first half of 2009. Our portfolios are, in general, made up of stocks that are relatively resistant to changes in the foreign exchange rate and we have been taking measures to contain any potential negative impact of currency market volatility.
Just two years after the official end of a decade-long period of deflation, Japan is once again poised to enter another period of falling prices. Faced with the rapid contraction of the domestic economy and fragile job security, Japanese consumers are tightening their purse strings, which has been putting huge pressure on prices. Sharp falls in commodity prices and the strong yen have enabled companies to cut prices aggressively. As lower corporate earnings will be translated into lower future consumer spending, we seem to have all the factors in place for a spiral into deflation. A growing number of pensioners with little money to spend will also increase deflationary pressure. We expect the deflationary pressure will continue to increase throughout the first half of 2009 unless there is a major reverse of commodity price or swift economic recovery. When selecting stocks to invest in, we bear in mind the impact and dynamics of deflationary pressure on the various industries and individual companies.
Pressure from the business community and voters worried about job security is forcing the government and the Bank of Japan to introduce a series of measures to try to stave off recession. The government’s initial stimulus package was criticised for being too small and unimaginative. A revised package included a sum of up to JPY 20 trillion to buy stocks from banks to prevent further falls in valuation. The government has been taking a continuous beating for various policy failures ranging from the economic slowdown to the mismanagement of public pension funds, as well as for what are deemed to be inappropriate comments and behaviour by its leader. This could trigger a large-scale political realignment in 2009. While such political instability in a recessionary environment will bring short-term uncertainty to the market, in the end it should lead to an administration that is more responsive to the economic challenges 2009 will bring, and that might possibly diversify the Japanese economy away from its strong focus on exports and stress the importance of domestic consumption by introducing more effective economic stimulus packages and other reforms.
For financially-strong companies, a recession is a good opportunity to outperform the competition and strengthen business portfolios. Corporate restructuring and M&A have historically been difficult to implement in Japan for various reasons. Traditionally, large-scale workforce restructuring has been viewed negatively and corporations were obliged to do anything possible to avoid laying off workers. Meanwhile, management teams rarely agree to sell up unless their businesses are under severe distress. However, after a decade of restructuring and the accumulation of large cash reserves, many Japanese companies are now taking advantage of the current recession to execute long-awaited strategic acquisitions and corporate restructuring in a swift and cost-efficient manner. A growing number of Japanese companies including large banks, insurance companies and even household names such as Panasonic and Nippon Oil are aggressively acquiring rivals to stay ahead of the competition and prepare for the post-credit crunch world. Others are reducing their workforce and repurchasing their own shares. It is unlikely that the surge of corporate restructuring and M&A will dramatically change the course of the market next year. However, coupled with various shareholder-friendly measures such as share buybacks, it should certainly help contain some of the negative impact of lower earnings, increase businesses’ long-term competitiveness and help share prices increase quickly once the market starts to recover.
Individual investors and domestic pension funds started to buy equities in large volumes after the dramatic market fall in September. Individual investors in particular, for the first time since the market’s recent peak in 2006, felt that equities had become cheap enough and that this was a good opportunity to buy blue-chip names at attractive prices. These new investors are helping fill the vacuum created by the departure of overseas investors, who owned close to 30% of the market prior to the crash.
| Financial Institutions | Non-financial Corp | General Gov’t | Households | Overseas | |
|---|---|---|---|---|---|
| FY87 | 40.2% | 34.3% | 0.8% | 20.5% | 4.2% |
| FY92 | 40.0% | 30.0% | 2.3% | 21.2% | 6.4% |
| FY97 | 38.6% | 25.0% | 3.4% | 19.6% | 13.3% |
| FY02 | 33.1% | 23.3% | 4.8% | 21.2% | 17.6% |
| FY07 | 25.9% | 22.6% | 5.4% | 18.4% | 27.7% |
Source: Bank of Japan, December 2008
The increasing diversity of willing buyers is healthy for the market and the growing presence of individual investors will help provide an important floor in what could be a volatile market this year. They could also play a role in speeding up the recovery by making further massive purchases once the market shows signs of definite recovery.
Investors are seeking strong returns in a market where growth has become scarce and companies are revising their earnings forecasts downwards one after the other. Small cap stocks, though, are far less affected by overselling and shorting by foreign investors than large caps, and they also have lower foreign exchange risk and export exposure. The strong yen and the government’s shifting focus from exporters to domestic-consumption-driven industries should also have a positive impact on this asset class. Small cap underperformance has been reversed and it has outperformed large caps in recent months as investors broadened their horizons in the search for growth.
There is still plenty of room for valuations to rise – the mid-cap bear market that lasted for more than three years did huge damage to stock prices, but selling finally appears to have abated in recent months. Fortis L Fund Equity Small Caps Japan contains several names that have a high chance of re-rating quickly once the market recovery begins in earnest.
2009 is set to be rocky and unpredictable for the Japanese market as the country is faced with an unenviable combination of rapidly-slowing corporate activity, rising unemployment, lower incomes and further falls in consumer spending. However, we still see attractive companies to invest in despite these problems – strong stock selection skills are vital in this kind of environment. Meanwhile, Japanese stock prices could be supported by further buying by individual investors and domestic pension funds. Moreover, there is scope for a short-term rally fuelled by economic countermeasures in the first half of 2009. Mid and small caps and domestic companies with minimal exposure to risks elsewhere in the globe and low foreign investor exposure should be the best performers until the global economy begins to recover and the yen falls in value.