Would a US Recession Negatively Impact Japan?

Includes: EWJ, FXY
by: Darrel Whitten

While the Fed and the Bush Administration are reluctantly moving to alleviate growing deflationary pressures in the U.S. economy and the financial markets nervously cheer with each new assurance, the jury is still out as to whether countermeasures will be fast enough and sufficient enough to avert a U.S. recession and the worst decline in U.S. housing prices in U.S. history i.e., deflation.

Now that the "R" word is out in the open in financial circles, there is also speculation about whether a U.S. recession could drag the Japanese economy into recession, given its perceived dependence on exports for current GDP growth.

There are three levels to the impact of a U.S. or global recession on Japan, a) direct exports from Japan, b) local sales of Japanese subsidiaries, and c) the contribution to total Japanese corporate profits from those sectors that would be most affected.

Three important potential negatives cannot be ignored. One, the automobile and electronic sectors are highly dependent on U.S. demand and moreover account for nearly 30% of total Japanese corporate profits. Two, further strength in the yen would only exacerbate the impact. Three, stock price formation in Japan is very dependent on foreign investors, who account for some 60% of trading value and own some 30% of all Japanese shares.

The good news is that Japanese corporate profits as of Q1 FY07 (April~June) are currently very strong, with ordinary income growing 20% YoY. Moreover, the yen would have to trend below JPY110 for an extended period of time to seriously dent corporate profits. Further, trading company, shipping, shipbuilding, and construction equipment profits would, a) be little affected by a U.S. slowdown, b) valuations are still very attractive versus the market average, and c) prices of major stocks are still above their medium-term (26-week) moving averages.

Thus while the Nikkei 225 should continue to trade in a channel between 16,000~18,000 for the next several months, we believe these sectors can still be bought given their value and limited exposure to the U.S. economy.