Japan is trapped by a chronic fiscal deficit, perverse Yen appreciation, price and wage deflation and low nominal (but high real) interest rates. Sustained economic decay seems inevitable, and in many ways the fact that Japan avoided a depression in the 1990’s given the scale of the asset bubble is remarkable. However, the ‘value trap’ that Japanese equities have offered investors for many years may finally prove to be simply remarkable value. The 60% book value discount to the MSCI emerging market universe is particularly bizarre when you consider the huge exposure of many leading Japanese exporters to the Emerging Asia growth story. Companies like Suzuki (46%), Komatsu (39%), Hitachi (52%), Daikin (40%) and Kawasaki (24%) all have between a quarter and half of their revenue growth generated in China and the rest of emerging Asia.
We’ve come full circle from the bubble days 20 years ago when brokers forecast 50,000 on the Nikkei as a foregone conclusion. As the global liquidity cycle peaks by early Q2 in the context of a synchronized and broadening economic recovery, it’s likely that the current consensus that developing markets will continue to outperform developed will prove misplaced. In that context, the developed market with the greatest upside potential against current expectations is Japan. I say this as a long-time Japan bear, for demographic and cultural reasons as much as economic.
In April 2008 for instance, I wrote that: ‘There has been one of those periodic outbreaks of bullishness on Japanese equities by several market commentators recently who posit that an inflation breakout leading to higher rates will be positive for stocks, and particularly banks. I would also, if that inflation were generated by domestic demand conditions rather than surging import costs…unfortunately, like China, Japan is suffering a rapid deterioration in its terms of trade.’ That supposedly bullish inflation ‘break-out’ didn’t last long as the world economy subsequently crumbled. Any investor in Japan should have no illusions.
Japanese industrial stocks offer the cheapest revenue exposure anywhere to emerging growth infrastructure and consumption growth. For the export dominated Nikkei, a sustained dollar rally against the Yen through the remainder of 2010 would be a key driver for a re-rating, and is likely if a solid US recovery forces an earlier Fed policy tightening than the consensus expects in H2. Japanese banks look equally attractive, as the balance sheet recession that began almost 20 years ago is finally coming to an end (while just beginning in Europe and the US).
