2012 Japan Outlook

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Looking Back

Perhaps the first thing to do is contrast the behavior of Japanese equities in 2011 with the stock markets of other major economies. As we approach year-end (and remember, this outlook is being written in early December 2011), the U.S. S&P 500 is effectively unchanged on the year, while the NASDAQ 100 is up 4%.The UK's FTSE100 is about 5% lower. Yet the Japanese Nikkei is down around 15% on the year and has more in common with the German DAX (down 14%) and China's Shanghai Composite, which has fallen by about 17%.

The Role of China

To a great extent, the sharp drop in the Nikkei shows the concerns that investors have for the Asian Pacific region, given its reliance on export markets in the U.S. and Europe. This is important to consider given Japan's strong position in the region and its proximity to China.

In 2011, the great decoupling theory, which posited that developing nations (such as China) would break away from the slow-growth developed world, has broken down. While growth in China and other smaller emerging countries have continued to outpace that of Europe and the U.S., the rate has slowed. Over the past year, China tightened its monetary policy sharply as inflationary pressures grew. In addition, it is increasingly concerned by local government debt and the prospect of a bursting property bubble. While many analysts point out that there is little leverage behind private property purchases (and consequently, the Chinese housing boom is built on firmer foundations than that of the U.S.), the same cannot be said of the commercial sector. On top of this, recent data showed that property transactions in urban areas dropped by 39% in October and 11.6% nationwide. This is a dangerous development as property construction accounted for more than 13% of China's economy in 2010. This means that developers will struggle to repay bank loans and this could have severe implications for the health of smaller banks and regional authorities. This has worrying implications for Japanese manufacturers, plant builders, and steelmakers as China has been a significant buyer of their products and services.

The Earthquake and Tsunami

The earthquake and tsunami which hit in early March were devastating on both a human and economic level. The tragedy led to production outages brought about by the disruption of supply chains. While the speed and scope of Japan's economic recovery has been impressive, there is continued public dissatisfaction with the response by the country's political class to the crisis. But most importantly, the situation at the Fukushima Daiichi nuclear facility is still unclear. While Japan recently declared the plant stable, there is a concern that melted fuel has burnt through the floor of the Number 1 reactor building and could lead to radioactive contamination of the ocean and groundwater. If this proves to be the case, then the implications are serious as the contamination would affect the safety of drinking water for a significant proportion of the Japanese population.

Politics and the Yen

This year brought another change in leadership for Japan. Yoshihiko Noda, who took over from Naoto Kan as Prime Minister in September this year, is the seventh Japanese Prime minister in just over five years. Unfortunately, his approval ratings have dropped sharply since he took office. His proposed doubling of the national consumption tax to 10% is particularly unpopular, suggesting that another change in leadership could take place before the end of 2012. This rapid political turnover points to an inability of policymakers to deal effectively with the Japanese economy. After all, the oft-cited "lost decade" is in reality a lost generation. And it isn't over yet. The last twenty years have been characterized by repeated stimulus packages as the government and central bank have repeatedly intervened to stem the bursting of the Japanese bubble, which occurred in 1989, and prop up the zombie banking sector.

The government recently announced its fourth supplemental budget (stimulus package) this year. These boosts to government spending are supposed to stimulate demand, create jobs, and kick-start the economy. So far, they have proved unsuccessful. Many see additional government spending as the only solution to Japan's lack of growth and deflationary problems. But others worry that politicians on all sides are too ready to add to an already record high fiscal deficit. Although critics have not been able to offer a palatable alternative, the policy of running huge deficits hasn't worked so far. The counter argument is that without such stimulus, Japan would have experienced its own Great Depression.

Fundamentally, Japan is in a dreadful state. The country has a gross national debt equivalent to 230% of GDP (this compares to around 100% for the U.S. and 160% for Greece) and terrible demographics whereby there are fewer productive workers supporting a growing number of pensioners. The savings rate has fallen dramatically, and Japan can no longer rely on a constant trade surplus.

Exports and the Yen

Japan is anxious to rebuild its export markets, but it is reliant on global recovery and a weaker yen. Despite repeated verbal and physical interventions, the rise in the yen has been relentless. The last significant intervention in October has done little to halt its rise, although concerns of further intervention have lessened its appeal as a safe-haven currency.

The strong yen has damaged Japan's vital export market, as has the escalating European debt crisis and uncertainty over the Chinese economy. To help counter the strong currency, exporters continue to move production abroad. This is already having an effect on the unemployment rate, which has begun to rise, although at 4.5% in October, it is still relatively tame. Remarkably, Japan looks like it could end up with a trade deficit for 2011.

Looking Forward

Japan's export-driven economy has led it to amass sizable foreign reserves. At the same time, Japanese citizens have been great savers. Because of this, Japan has been able to fund its budget deficits as there has been plenty of domestic demand for Japanese Government Bonds (JGB) with foreign ownership around just 5%. A recent issue of "reconstruction bonds" is proving popular as buyers have been offered a commemorative gold or silver coin to counter the negligible yield. Yet Japanese government bonds are currently rated AA- and are in danger of further downgrades.

By some measures, many Japanese equities are relatively undervalued. Many Japanese corporations are awash with cash and have share prices which are close to "book value" or the net value of their assets. So it could be argued that the Nikkei is cheap at current levels. However, these factors have existed for a number of years now, and an unwillingness to spend cash suggests that corporate executives remain cautious about the future outlook. As we've said before, Japan's lost decade is now a lost generation. So, while the Nikkei may be good value on a relative basis, there are likely to be difficult times ahead for equity markets.

Going into 2012, investors will continue to worry about Japan's ability to fund its existing debt, and the danger is that, if yields creep higher, the problem gets more acute. The country's debt issuance is set to rise further, but may not be met with sufficient demand as the domestic savings market shrinks. If yields have to rise to compensate, servicing the debt becomes ever more expensive. These concerns will continue as headwinds for Japanese equities in 2012.

- David Morrison contributed to this article

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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