Sweet spot

Buttonwood

Dec 20th 2005 TOKYO
From The Economist Global Agenda

It’ll have its scares, but Japan is still the best story in town

AN ACQUAINTANCE of Buttonwood’s, an economist at a great investment house, is just back from a round-the-world road show to charm clients about Japan. Everywhere he went, he played to packed houses: there is no doubt that Japan is now the big investment story. Yet interest in Japan among fund managers is not always matched by familiarity. Even this travelling economist found himself briefly lost for words when one manager in, let us say, Milwaukee raised his hand to say that, as a young card, he had once greatly enjoyed driving a thing called a Datsun about town, a delightful little car if rather prone to rust. What, the manager asked, did the economist think now about a punt on the company?

Now, the currencies in which Buttonwood deals are scepticism, a contrarian streak and a sense of dark foreboding about the consequences of human folly. So when it has escaped a potential guardian of your retirement pot and mine that the Datsun badge last adorned a vehicle in 1980; that Nissan, the parent company, subsequently slid into alarming decline until it was rescued by Renault; and that what happened next is one of the great turnarounds in business history: then you might think it is time to bring the curtain down on the sizzling story that is Japan’s stockmarket this year (chart 1). After all, while this gentle man dreams of his old Datsun, the annual bonuses at the big investment banks’ Tokyo branches have already been calculated, and the new Testarossas already ordered—and rare indeed is it that equity markets can sizzle two years in a row as Japan’s has done in 2005, when it rose by two-fifths.

Signs of froth in the Japan market are there for all to see. Heavens, even the Tokyo Stock Exchange, after a decade of torpor, is overwhelmed by the volumes now being sent through its systems. But can it not happen that sometimes, just sometimes, the contrarians are wrong and the consensus right? At any rate, do not take as an excess of seasonal spirit the prediction by this Asian incarnation of Buttonwood that for the next year or four Japan will be the happiest place to prosper in as far as the asset markets of the world are concerned—and that even whatever goes on in China will prove, from an investor’s point of view, to be a mere distraction.

This columnist’s premises are the following. First, the world’s second-biggest economy has started—but only started—on the path out of the morass formed by a decade of deflation. As the recovery builds speed, it is likely to be sustained by a virtuous circle of forces.

Paul Sheard, chief Asian economist at Lehman Brothers, talks about the economy’s transmission mechanisms, broken for so long, starting to engage again. In the real economy, he says, company restructuring, more focused management and deregulation have boosted a corporate sector that at last is hiring more and paying more. Incomes are rising for the first time since the late 1990s. That bodes well for a recovery in consumption.

On the monetary side, signs are growing that the Bank of Japan (BoJ) may one day no longer be pushing on a string. Lending by private-sector banks is growing (just) after years of shrinkage, even if total bank lending is still in negative territory. Jesper Koll, chief economist at Merrill Lynch in Tokyo, even sees hints of a return of rational pricing in credit markets. Since the beginning of October, he notes, when the BoJ started to suggest in earnest that it would not provide the banking system with free money forever, spreads between the best and worst of corporate credits have widened sharply.

The second premise is that the recovery will continue to be accompanied by supply-side reforms amounting to a revolution in the way capital is allocated. The government also promises fiscal discipline. On December 20th it unveiled its budget for the fiscal year that begins next April: it proposes to cut public spending by 3% and to cut bond issuance for the first time in nine years.

Third, and crucially, the central bank will continue to provide free money for the foreseeable future. For despite today’s tensions between the BoJ and the government over the course of monetary policy, the central bank has little room for manoeuvre. That is because it has committed itself not to tighten monetary policy until “core” inflation has turned positive for “a considerable time”. For the moment, core inflation has not turned positive at all—though figures for November or December may mark that momentous change. Count on free money for a good year more, and probably longer. With inflation on the rise, real interest rates would even turn negative.

All well and good, but none of this would establish the bull case if asset markets were already overvalued. But they are not. To take just one stockmarket measure, the earnings yield on the Topix index is still a highish 5% or so, making shares a far richer buy than bonds (chart 2). As for property, fizz has indeed returned to central Tokyo and that is now spreading outwards. But, on average, residential prices are back to levels last seen in the early 1980s, while commercial property prices are where they were before the mid-1970s, when this writer was in short trousers.

As for the risks to this happy scenario, some think there are none; Buttonwood does not carry the consensus so far. One risk is premature tightening by the BoJ. Another is a rise in bond yields that imposes crippling costs on the service of the government’s gargantuan debt. And there is always the lurking thought that a repeat of the great earthquake of 1923 is overdue.

Apart from those, the risks, as strategists quaintly put it, are pretty much all on the upside. Mr Koll, one of the most upbeat forecasters, thinks that Japan’s annual productivity growth over the coming decade will average 2.8%, versus 1.5% over the past decade. Whether or not you buy that much bullishness, reflation means that surprises in corporate profit growth over the next few years are more likely to be pleasant than nasty.

A final statistic, courtesy of Lehman’s Mr Sheard. Since the beginning of 1999, Japanese households have greatly increased the very safest and most liquid of assets—cash and money held in demand deposits at the bank: these have risen as a proportion of nominal GDP from 21% to 39%. They have been heavy net sellers of shares, to the tune of ¥25 trillion ($215 billion) since the market bottomed, while foreigners have dived in. Ordinary Japanese, in other words, are still hunkered down against deflation.

If the economy does now reflate, that mountain of cash is bound to move with expectations, with heady consequences for property and share markets. Could it be, in other words, that the domestic view of Japan’s prospects, overly jaundiced by the awful experience of the past, is in fact the dominant consensus? And could it therefore be that Buttonwood remains a contrarian, honour intact?

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