Seeking Alpha

A Look at Japan ahead of Koizumi's Exit

by: Steven Towns September 18, 2006 | about: DFJ / DNL / DXJ / EWJ / ITF / JEQ / JOF / VPL

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Japanese stocks aren't likely to do much over the next week and a half with the Nikkei 225 Stock Average seen trading somewhere between 15,500 and 16,000. However, a potentially big political catalyst not exactly receiving much press in the U.S. is the upcoming leadership change as Prime Minister Junichiro Koizumi ends his second term in office on the 26th.

Although the Japanese economy has recovered in a huge way since its initial worsening after he first took office, a lot of questions and uncertainties remain. I think the best strategy for the rest of the year is a bottoms-up stock picking approach and/or a conservative accumulation approach via ETF.

Note that the Tokyo Stock Exchange was closed today for Respect for the Aged Day -- trading resumes tomorrow.

It's increasingly unlikely that there will be any sort of rally like there was last September following Koizumi's snap election victory securing the privatization of Japan Post. Chief Cabinet Secretary Shinzo Abe continues to be heavily favored to succeed Koizumi, which if it happens would at least avert a sell-off of stocks since it would ease concerns about any immediate increase in the national consumption tax. Raising the national consumption tax in relation to paying down public debt is becoming an increasingly heated debate but one that Koizumi has mostly put aside as he attempted to cut wasteful government spending, urged banks to cleanup their books, and pushed for privatization of Japan Post.

Most pundits agree it will be hard for Koizumi's successor to follow exactly in his footsteps of promoting reform given his charisma and ability to remain firm against strong opposition to reform. Bloomberg.com reports Shinzo Abe's economic policy might be summed up in three words: "Do no harm." Some pain has already been inflicted on Abe because Heizo Takenaka, the mastermind behind Koizumi's economic reforms announced his planned resignation from government effective the 26th, giving up both his cabinet position and upper house parliamentary seat.

Two of the most respected Japan economists have different perspectives on Takenaka's resignation. The Financial Times reports Jesper Koll of Merrill Lynch said, "The golden age of pro-market reform is over." The sense of crisis during the Koizumi administration is over as the economy is now in its fifth year of growth. Robert Feldman of Morgan Stanley however, argued Abe is 'more committed to a market-oriented view of the economy than people realise[d].' Takenaka said the following at a press conference, "My role in the political world has been to support Prime Minister Koizumi." Takenaka added that he will follow Koizumi and vote for Abe and he said he'll support Abe from the private sector. Feldman said Takenaka's five-year political foray was "a brilliant, towering success," adding that "a samurai can’t serve two masters."

First, a look at the Nikkei 225 Stock Average and MSCI Japan Index:

On the week the N225 gained 0.5%, since the end of Q2 it is up 3.6%, since the end of Q1 it is down 7.0%, it is down 3.0% year-to-date, and up 22.0% over the past 52-weeks.

According to Nikkei Shimbun data, the N225 components as a whole trade at 1.97x book, 19.22x forward earnings, 19.89x trailing earnings, and have a current dividend yield of 0.99%.

As of Friday's close, the MSCI Japan Index had the following returns:

In local currency:

Daily: -0.316%
Month-to-date [MTD]: -2.415%
Quarter-to-date [QTD]: 1.045%
Year-to-date [YTD]: -0.858%

In US$:

Daily: -0.468%%
MTD: -2.664%
QTD: -1.765%
YTD: -0.483%

The iShares MSCI Japan Index ETF (EWJ) is the most actively traded Japan fund in the U.S. and has competitive management expenses. Alternative investment funds include:

iShares S&P/TOPIX 150 (ITF)
Vanguard Pacific ETF (VPL)
Japan Equity Fund (JEQ)
Japan Smaller Capitalization Fund (JOF)
WisdomTree Japan Small Cap Dividend (DFJ)
WisdomTree Japan High-Yield Equity (DNL)
WisdomTree Japan Total Dividend (DXJ)

Now a look at the Japanese economy:

Ahead of the IMF and World Bank annual meetings in Singapore, Bank of Japan governor Toshihiko Fukui made the following comment to reporters:

"From here on, we remain forward-looking. We will expand our horizon and proceed our policy after checking all kinds of possibilities and risks." (Forbes.com XFN-ASIA newswire)

Bank of Japan board member Atsushi Mizuno had the following to say:

"We have been seeing some mixed reports recently with both strong and weak sides. We don't necessarily interpret data the same way the market does.'' "Things are in line with our scenario'' (that prices are rising and the economy is expanding). "I want to emphasize that that means fine adjustments will continue to be made to interest rates." (Bloomberg.com)

The mixed reports Mizuno mentioned are:

Japan's Slightly Upward Revised Q2 GDP Overshadowed by Weak July Machinery Orders
Japan's CAPEX Data Surprises to Upside, but BoJ Rate Hike Unlikely
Japan: Unemployment Down, GDP & Consumption Up
Higher Inflation in Japan Might Be a Good Thing -- contains historical CPI, personal consumption, and GDP charts
Japan: 2 Sets of CPI Data, 1 Conclusion -- BoJ Won't Raise Rates Soon

Positive developments:

Declining oil prices could help consumer sentiment/spending; Crude oil prices down about 20% since mid-July peak although gasoline prices remain near record highs in Japan.
Improved consumer sentiment/spending could carry over to equities investing
Online stock brokerage price war continues forcing firms to innovate with some now are offering "night trading." A Merrill Lynch analyst in Tokyo is not so optimistic but comments, "Night trading is an attractive service online brokers can provide to customers, although I don't think it will prove popular. Liquidity will be smaller than at Japan's major exchanges, meaning prices may not be favorable to investors." Can't argue with that but other popular net brokerages are set to offer the same service with trading limited to several hundred stocks so there is a chance of decent liquidity to make trading worthwhile. (IHT.com/Bloomberg)

Negative developments:

Japanese investors continue to seek yield and are putting downward pressure on the yen as they look for higher returns overseas: 'Total net assets of foreign-currency investment trusts in Japan reached 24.2 trillion yen ($205.6 billion) in August, the largest since 1989 when monthly data was first compiled by the Investment Trusts Association. Of the total, 4.3 trillion yen was invested in foreign equities and 16.9 trillion yen was allocated to foreign bonds. Two years ago, funds only had 8.6 trillion yen of assets in overseas debt.' (Bloomberg.com)
Ten Japanese think tanks estimate the BoJ's quarterly short-term economic survey called tankan for September (to be published on Oct. 2nd) will have a slightly lower reading than the prior survey in June. (Mainichi Daily News) A lower reading almost guarantees there will not be another rate hike this calendar year. At the same time it renews concerns over the health of the economy and creates doubt about the recovery/expansion.
The Cabinet Office announced that the index of leading economic indicators for July was downward revised to 27.3 from an original reading of 40.0. A reading of >50 indicates expansion over the next 3-6 months, <50 indicates contraction. (Forbes.com XFN-ASIA newswire)

Mixed:

The Cabinet Office reported "growth in consumer spending has been slowing recently." Although the government did maintain its assessment that the economy is "recovering" and it deleted the word "deflation" while changing its wording to (the government aims to) "secure a stable trend in prices" from "securing the end of deflation." (Bloomberg.com)
Note that despite the Cabinet Office's overall positive assessment of the economy it did downgrade private consumption blaming a slowdown on weather and saying it needs further data for confirmation. It also downward revised exports as overseas demand is seen "leveling off." (Reuters.com)
The BoJ reported households' financial assets as of the end of June fell slightly below the 1,500 trillion yen mark ($12.74 trillion). The balance of 1,499,294.3 billion yen is higher than it was at end of Sept. '05 but is lower than Mar. '06 due to a decline in the stock market. Overall assets are up 4.5% on the year and according to the BoJ, assets increased due to higher income and wages. Cash deposits fell 0.7% y-o-y signaling a shift toward riskier assets. (Easybourse.com) Mixed feelings here because of individual investors' continued caution towards domestic stock market. More sustained buying by locals is necessary to support overseas buying if the Nikkei 225 is to recover and expand beyond 16,000.

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