Positive sentiment at five year high for Japan stocks

By Richard Newell of Global Fund Services

People are once again starting to take notice of Japan as an investment destination. With so much recent attention focused on China, Japan has become the forgotten giant of Asia. This is understandable in the context of its former glories. But as the biggest and most investible economy in Asia, you simply cannot ignore it for long, especially now there are signs that the recovery may be more sustainable looking forward over the next five years.

There's definitely a buzz about Japan, for the first time since the turn of the decade, when Japan suffered the most recent of its dramatic reversals. The main equity market indices, the Nikkei and the Topix, have both hit four year highs recently and to judge from the positive sentiment among investors, particularly foreign buyers, there appears to be considerable momentum.

A panel of hedge fund managers was recently asked where their money was being allocated to. They all identified Asia as the key region and Japanese equities long and short as the key market. A recent survey by Citywire in the UK showed that fund of funds managers are increasing their exposure to Japan as confidence rises. Boston-based research group Emerging Portfolio has identified record inflows to Japanese funds since July. Over US$6.5 bn has been invested in August, September and October, the highest quarterly figure for five years.

Morgan Stanley's Andy Xie puts it like this: "During two weeks of meeting with investors in the U.S. and UK, I found that they are unanimously bullish on Japan. They are investing heavily on the view that Japan is emerging from deflation, taking long positions in the Nikkei and short positions in Japanese government bonds (JGBs)."

The rally in Japan started in August, when reports showed that economic growth had started to accelerate. Overseas buying fueled the gains. In October, 54% of global money managers said their stakes in Japanese companies exceeded benchmarks, according to a monthly survey by Merrill Lynch. That was up from 46% in September.

Respondents to October's Citywire Fund of Funds Survey, which looks at the views of multi-managers running less than £4.5 billion of assets, were almost universally positive on Japan. More than 80% said they believed a long-term bull market had now emerged. The rest of the respondents were still undecided but no one was negative.

Insight's fund of funds manager Patrick Armstrong says: 'The combination of political reform and an end to deflation are the most compelling reasons to be bullish on Japan. An increase in inflation could see Japanese pensions, which are dramatically underweight in equities, start to buy.
''I continue to be bullish on Japan,'' said Joji Maki, Tokyo-based head of Japanese equities at Baring Asset Management (Japan) Ltd. ''We're seeing evidence of domestic-demand led recovery that we hadn't seen before.''

Andy Brunner, chief investment strategist at Forsyth Partners, a UK-based fund researcher and investment manager says the recovery is real: "Enough structural changes are taking place for this to be a real turn in the economy and a real turn in the market."

Merrill Lynch's latest global fund manager poll showed that Japan was far and away the region where investors are most like to be overweight over the next 12 months. Managers also picked the yen as the currency most likely to appreciate compared with the dollar and the euro.

The question of if and when domestic investors become significant buyers of domestic stocks will be the key issue for the rest of the year, according to Christopher Wood, Hong Kong-based strategist at CLSA Asia-Pacific Markets. "When the big domestic institutions return, they will start by buying blue chips. This is why the blue chips are due a period of outperformance," he said. Klaus Wiener, head of research at AMB Generali Asset Managers in Cologne, agrees that if the Japanese domestic investors become major buyers, that could have a further impetus. Wiener added: "We are very bullish on Japan."
France's AXA Investment Managers has steadily increased its Japanese equities exposure since August. "If growth is sustained and restructuring continues, then earnings could surprise on the upside," it said.

Forsyth's Andy Brunner says his firm currently has a 15.5% weighting in Japanese equities compared with a 10% benchmark. "We wonder whether we ought to go to a 20% weighting," he adds.
In 2003, the Japanese market rose 23%. Then last year, it rose 8.5%. In 2005 the Nikkei is up nearly 13% so far while the broader Topix has gained more than 15%. It has been the domestic sectors, such as financials and real estate, along with small companies (which generally have a more domestic bias), that have driven this performance. The IPO market has also been active, raising 75% more than the previous year. The overall rise in volumes is a sure sign that structural changes in the Japanese economy are finally beginning to have a positive impact.

Specifically, the Bank of Japan has in the past four years encouraged Japan's banks to properly set aside provisions for their bad loans, estimated at something like 52 trillion yen. The BoJ has made a number of concessions on emergency aid and stock buy-backs to aid this process. And in tandem with a hard line from the Koizumi government, progress does appear to have been made. Bank lending is now expanding for the first time in many years.

Koizumi's recent landslide election victory has helped strengthen sentiment in the already strong Japanese stockmarket. UK fund manager Framlington says there are a number of reasons to expect the market to remain well underpinned as GDP numbers have been revised up, with encouraging progress in domestic investment and consumption: "The pressing structural problems in Japan remain dangerous (for example, public debt is 160% of GDP, the worst in the developed world) but for the time being foreign buying of Japanese equities is likely to remain supportive of the overall market level."
Koizumi is seen as a reformer, someone who recognizes that Japan's institutions need to be radically overhauled before the country can truly begin to shake off the legacy of the 1980s asset bubble. As Macquarie notes though, Koizumi is not an economist "and he has never displayed that type of "grand vision", or even the basic understanding of economic concepts that would be a pre-requisite for such a plan. Koizumi's main direction is political reform, and this sometimes has economic dimensions, such as the cuts in public works spending or the privatisation of Japan Post, a massive institution including Japan's largest insurer and a savings bank that is the world's biggest deposit-taker.

Koizumi went to the polls after his plan to privatise Japan Post was rejected by conservative members of his party, the LDP. His stunning success, which gives the LDP and its Buddhist coalition partner, New Komeito, a two-thirds majority in the lower house of parliament, reflects the feel-good factor that has begun to turn Japan around.

"Japan Post is like an enormous wet blanket over Japanese life," said Mark Burges Watson, co-founder of speciality equity researcher and brokerage Japaninvest. "It has acted as a massive dampening on Japan's financial spirit." He noted that the current rally was unlikely to keep going in a straight line but said there had been a fundamental change in Japan and that this was not another false dawn. "The corrections will become smaller and the rallies will become larger. The crucial reforms in Japan are under way and this is a multi-year bull market."

It is important to recognise that this is not the same as the China story. It does have some similarities in terms of recovery and re-rating, at least superficially. But this is a country with high tech sophistication, broadly spread wealth and a social structure that functions well by global standards. The only thing holding it back is poor management and accountability at the highest levels of its financial system and in corporate life. As the example of Sony perfectly illustrates, it is not enough to be at the leading edge of technology and have great products if you can't make a profit.

Risks to the positive outlook appear to have diminished. A rise in exports, together with
indications that global growth has picked up speed, pushes the risk of a fall in exports further
out into the future. China is a playing a part in Japan's recovery. Many firms have bought factories in China to cut manufacturing costs and woken up to the possibility of the fast-growing economy as an enormous market. It is now Japan's largest customer.

In the short term, Morgan Stanley is making a prediction for "euphoria to continue into 2006 led by the deflation-reversal theme and (we) reiterate our projections for TOPIX reaching 1,700 points (16,500 Nikkei 225) on heightened monetary accommodation with a negative real policy rate and weak yen trend.