Japanese Stocks: Value Trap?

For the past year, investors have been caught in a quandary with respect to Japanese stocks. Japan has seriously lagged Hong Kong and Chinese equities and investors have been forced to make hard decisions about whether to chase performance or invest for the long term. While investors are touting Japan as cheap based on a number of valuation indicators, one has to take into account some significant factors that are shaping the current investment climate.

Despite many research reports to the contrary, Japan has yet to emerge from deflation, as rising prices have been caused by commodity price inflation rather than an actual increase in consumer demand. As Japan imports almost all of its commodities, it has been impacted more so than any other country, with the possible exception of the United States, by India and China joining the global economy. Japan, like the United States, has had to push to obtain the necessary raw materials in order to drive manufacturing.

Unlike the United States, which as a military power, is superior to any nation in the world and can use that power for influence, Japan has no real power on the international stage. Japan chooses to play a more humble role which has hurt the country during this economic cycle as China and India have been more aggressive in signing international agreements and obtaining raw material supplies. During this cycle, rising commodity prices flowed through the production chain down to the consumer level without a corresponding increase in salaries. The Japanese worker absorbed the commodity price increases through low wage growth. Retail sales have grown at a slower pace than expected during this cycle due to the slow growth in personal income. On the political front, the longer the LDP remains in power the more likely the government and Bank of Japan slip into past non reformist policies. It does appear that change may be on the horizon as the DPJ has been gaining steam with the electorate, as evidenced by their ability to win control of the upper house last July. Depending on how strong they feel in their position with the electorate, we may see a challenge to the LDP in the spring with the appointment of a new head at the Bank of Japan failing and possibly leading to early elections.

Former Prime Minister Junichiro Koizumi was an aberration in the Japanese government in that he cut public works projects, privatized the post office, and carried out selective reforms while continuing to respect his political base through controversial appearances at war memorials. Shinzo Abe was unable to muster much support following Koizumi and his tenure was marked by a return to the traditional, glacial style of Japanese politics. That looks to continue as the Japanese government begins to claw back at reforms and reinstitutes a more traditional Japanese style of business. Most affected are the banking and real estate industries.

Should the Bank of Japan decide to raise interest rates they would not choke off economic growth; affecting only the carry trade. If the carry trade were to unwind in its entirety the result would be a massive disruption in the global financial system as risk and speculation would disappear from capital markets. However, the return to a more traditional Japanese government means that interest rates will continue to remain low for some time.

Businesses have started to adapt to the changing environment by outsourcing entry level manufacturing to other Asian countries in a manner similar to how Boeing and Airbus manufacture airplanes. The components are manufactured globally and sent to their respective home factories for final assembly and export to the world. In this manner, they can lower costs while continuing to maintain an export advantage.

Economic growth will continue as Japan outsources basic and entry-level manufacturing to Thailand while maintaining final assembly and export from Japan. Commodity inflation would be exported offshore with savings being made up for in lower labor costs. In Japan's economic numbers, import numbers will rise reflecting the entry level manufacturing imports with additional value being added in the final steps of the manufacturing process. The export value of the product then rises contributing to a larger trade surplus.

Finally, the fear of China replacing Japan as the manufacturer to the world has caused the Japanese to devalue the yen much like the dollar has collapsed versus the world's currencies. The only reason this has not been mentioned more by the press is that the world is more concerned with the glacial appreciation of the Chinese yuan, but there are important reasons behind the slow appreciation, most of which relate to social stability.

Fund managers looking at Japan may claim that the market is cheap, but cheap markets do not always mean value. As long as Japan continues to revert back to a more traditional style of government and outsources entry level manufacturing while holding down wage growth, deflation is likely to continue. Mangers looking at Japan should seriously consider the possibility that the economy remain mired in a deflationary spiral while looking to avoid a possible value trap.