Morgan Stanley's Robert Alan Feldman: FAQ on Japan for Investors (EWJ, ITF, VPL)

One of the most respected Japan analysts, Robert Alan Feldman of Morgan Stanley (MWD) Japan, has put together a FAQ for Japan investors triggered by his colleague Steve Roach's visit to Japan last week. A must-read for those interested in a better and much deeper understanding of what's going on in Japan and what to look for going forward. Full story:

What’s New

Intense meetings with different types of investors, triggered by my colleague Steve Roach’s visit to Japan this week, exposed the main concerns of Japanese investors.

Conclusions

Investors in Japan — whether foreign or domestic — are primarily concerned with longer-term structural issues than with cyclical ones. That said, there remains considerable debate about what the Bank of Japan will do, and when.

Market Implications

(1) The investor consensus sees a further weakening of the yen, as interest rate differentials expand further. Dollar long investors are beginning to consider exit policies. (2) Longer-term considerations only underscore the need for policies to improve resource allocation and for corporations to raise efficiency, especially through capex.

Risks

Foreign risks abound. A weaker US would slow direct export demand and also hurt Japan’s trading partners in the region. The concomitant fall of commodity prices would not likely be enough to offset these losses. At home, there is always the chance of political disruption of the reform process. In addition, a premature tightening by the BoJ could derail recovery expectations and restart deflation.

The whirlwind visit of my colleague Steve Roach to Japan this week gave a unique opportunity to see how investors here — both domestic and foreign — mix Japan questions with those about the world economy.

Can Japan Really Grow?

One question on everyone’s mind was whether Japan can really achieve sustainable growth. At our largest seminar, the show of hands was about 3:1 in favor of sustainable growth. However, in smaller meetings, there were a few more skeptics. One line of thought focused on the weaker sectors of the economy, for example, retail and especially small business. How could Japanese growth be sustainable when these sectors are still suffering? My answer is that these sectors are suffering due to a lack of efficiency rather than a lack of demand. The shrinkage of these inefficient sectors — and transfer of resources to more efficient ones — is actually a sign of revival rather than stagnation. The challenge for policy and for business is to retrain and reabsorb the redundant workers.

So far the process appears to be working. The recovery so far has brought an increase of the labor force, despite the continued decline in the working age population. Most entrants have been absorbed, exempting the Brownian motion of monthly data. (The rise of the unemployment rate in October appeared to be one such blip, in view of the hard-to-explain drop of seasonally adjusted unemployment in September.) Much is left to be done, especially in raising the capital-labor ratio in education. The latter challenge, however, is best seen as an opportunity for entrepreneurship, rather than as a threat.

Won’t High Energy Harm Japan?

Many investors were also concerned that high energy prices would harm Japan. Indeed, Steve echoed this sentiment when he warned that investors have become complacent about oil price impact — citing the low apparent growth of US consumption in the current quarter. There are thus two parts to the question, the transfer effect of higher oil prices taking money from Japan and giving it to oil producing countries, and the effects of income changes in Japan’s trading partners on external demand.

The first issue is important, but not so crucial as in earlier years. True, the value of crude oil imports rose by 0.7%-ppts of GDP between 3Q04 and 3Q05. But the ratio of recurring profits to GDP rose by about 1.5%-ppts of GDP in roughly the same period. Since Japanese corporations historically have absorbed most of the fluctuations of oil prices into earnings, and since the oil price increase is occurring at a time of high profits, the income transfer impact is not so painful.

Moreover, trading partners are many and varied. True, the US has had some serious impact from oil price increases. However, China has imported less oil this year than last. Moreover, exports to the Middle East have accelerated sharply since mid-year, as have exports to Mexico, Venezuela, and Nigeria. On balance, overall exports are still growing at about 6%, on a 12-month moving average basis.

Another part of the energy equation is technology. Japan retains a comparative advantage in energy efficiency, and has a relatively high proportion of electricity derived from nuclear power. Hence, Japan is less vulnerable to energy shocks than most other industrial nations.

What will the BoJ Do?

As Steve pointed out so eloquently, the move from extreme ease to neutrality is a challenge for central banks around the world. This is very much the case for the BoJ. Clients are asking why there is so much controversy in the relationship between the government and the BoJ, and what the BoJ will do.

The controversy stems from differing agendas. For the BoJ, the normalization of interest rate policy — even if only to slightly positive interest rates — is crucial. The money market has been dormant for years, and many firms (particularly small firms) are forgetting the business discipline imposed by interest payments. For the government, however, the key issue is fiscal reform, and so the coordination of fiscal and monetary policy is crucial. Already, rollback of the remaining part of the emergency tax cuts of the late 1990s is scheduled for 2006. Hence, the government is reasonably worried that a premature tightening of policy would re-ignite deflation.

When we polled clients, opinions on whether Japan would be out of deflation by mid-2006 were split about 50:50. However, a clear majority believed that the BoJ would not end the zero interest rate policy (ZIRP) until 2007. This majority view coincides with my own. The risk/return tradeoff for the BoJ on an early end of ZIRP is simply too unfavorable, especially in light of political talk about modifying the BoJ law.

The implication of this conclusion on interest rate policy for the currency market was of most interest to investors. For now, with the BoJ keeping ZIRP and the Fed continuing to tighten, interest differentials will continue to widen, and the yen will continue to weaken. However, an end to Fed tightening may well become visible in 2006, as will an end to ZIRP. At that time, the charm of the dollar could fade, as my colleague Stephen Jen has begun to mention. Whether this happens in early 2006 or late 2006 is not clear. However, investors who are very long dollars are beginning to design exit policies, and this in itself could begin to slow the yen’s slide.

Source: Morgan Stanley

Comments

[K Hyde:]

For readers interested in a follow-up: Mr. Feldman will speak at Japan Society on Fri, Sept. 28, 2007 at 11:30 am--E. 47th St. betw. 1st & 2d Aves.

Topic: State of Japan’s Economic Health from the perspective of traditional macroeconomics and development economics, as well as the impact of fast-changing demographics and international trade.

Reservations: visit japansociety.org and click on the lecture title, or click on top-menu item 'Global Affairs' and then 'Upcoming Corporate & Policy Events.'

Note: I write for Japan Society and thus can't claim impartiality, but this should be a lively event.

2007 Sep 24 09:47 AM