Morgan Stanley to Reduce Japan Weighting (MS, EWJ, ITF, VPL)

Includes: EWJ, JEQ, JOF, JPXN, MS, VPL
by: Steven Towns

MSNBC/ has just reported that Morgan Stanley (MS) has "declared an end of the Japanese equity market rally and plans to reduce its weightings in the country and invest more in the US instead..." FT journalist David Ibison adds that this is the first major finance house to make such a call. Morgan Stanley believes the market has peaked despite recognizing the ongoing economic recovery and improving fundamentals.

U.S. valuations are seen as more attractive after the Nikkei 225 Stock Average has increased 15% since November and almost doubled since April 2003. Morgan Stanley said it is prepared to rebuild positions in Japan if there is a meaningful market correction. Although I respect Morgan's decision and reasons, I believe the Nikkei 225 and broader market (TOPIX 1st and 2nd section) will outperform U.S. equities again this year. As for a meaningful correction, I assume the "Livedoor Shock" induced correction was not enough (approx. 7%) and Morgan is looking for at least a full 10%. Don't expect Morgan overweight again anytime soon because Q4 (Jan-Mar) should bring another strong period of earnings with improving domestic demand and consumption along with the weak yen. Full-text below with new Morgan Stanley weightings in bold.

Morgan Stanley to cut Japan weightings
By David Ibison in Tokyo
Updated: 10:10 a.m. ET Feb. 7, 2006

Morgan Stanley, one of the world's leading investment banks, has declared the end of the Japanese equity market rally and plans to reduce its weightings in the country and invest more in the US instead, the first major finance house to make such a call.

The decision goes against the asset allocation strategies of all the other major investment banks, which believe a combination of corporate restructuring and the sustained revival of Japan's economy means its markets are poised for a much longer bull run.

The benchmark Nikkei 225 index closed at 16,721 points on Tuesday, around double the level at which it was trading in April 2003.

Morgan Stanley said it was prepared to rebuild positions in Japan if there was a meaningful market correction, indicating it believes the market has now peaked.

The investment bank pointed out the decision did not reflect the fundamentals underlying Japan's economic recovery but was instead based on the fact that the Japanese market had risen 15 per cent since the end of November, making US valuations relatively more attractive.

"We recognise this is a strongly counter-consensus shift and goes against powerful portfolio flows out of the US and into emerging markets and Japan over the past few weeks [but] in our view these flows are approaching the point of pushing Japanese equities beyond fair values," it said in a note to clients.

The US bank said it would now be 55 per cent weighted in the US compared with 45 per cent previously; 10 per cent in Japan compared with 15 per cent before; 25 per cent in Europe, unchanged; 5 per cent in developed Asia ex-Japan; and 5 per cent in emerging markets, down 5 per cent.

The market rally in Japan has so far been driven by foreign investors such as Morgan Stanley. Foreigners have invested Y26,600bn in Japanese markets since their low in April 2003 and in the last two months alone have invested a further Y1,500bn.

In stark contrast to Morgan Stanley's position, fellow US investment bank Lehman Brothers has just abandoned its long-held bearish stance towards Japan and started arguing that the country's markets are poised for a strong rally – a widely-held position among other houses.

Paul Sheard, Lehman's chief economist for Asia, said: "The story on Japan is not a valuation story but a call on whether you think Japan is coming out of deflation." Lehman is 15 per cent weighted in Japan compared with a FTSE benchmark of 10 per cent.

Mr Sheard pointed out most economic indicators pointed to a period of reflation. "As the potential turns to reality, equity markets stand to go higher," he said.

Local institutional investors have so far shunned Japan's market rally, but there are now signs this trend is starting to reverse with net buying by individuals and investment trusts picking up – a long awaited development that could spur further gains in the markets.

"If the economy were indeed to reflate, domestic investors eventually would have to recognise that reality and start repositioning defensively-slanted portfolios, with positive consequences for stock market momentum," Lehman said.

Source: MSNBC; Copyright The Financial Times Ltd. All rights reserved.