Asian giant slowly gains momentum
After years of stagnation the Japanese equity market has finally started to stir. BT Funds Management chief investment officer Craig Stobo discusses what's happening and the outlook for Japan.
Sunday, May 9th 1999, 12:00AM
The Japanese equity market, as measured by the Topix index, rose 16.6 per cent in local currency terms in the three months to March 31. This was one of the strongest performances in the region. A confluence of policies, evidence of economic stabilisation, and growing signs of company restructuring drove a marked change in sentiment, which in turn saw increasing inflows into the market. This was particularly noticeable given the market was able to rise in the face of a marked increase in sales of cross shareholdings from domestic banks and corporates ahead of fiscal year end in March.
Economic Outlook
The economy has begun to show signs of stabilisation, with industrial production rising for three out of the last four months. The economic stabilisation, which is supported by both a substantial inventory draw down and fiscal policy measures has been well telegraphed to investors.
In addition to these short-term measures however, other more fundamental changes are occurring. The Bank of Japan, which has guided overnight interest rates down to virtually zero is becoming more proactive, ahead of our previous expectations. With changes in short term interest rates becoming somewhat meaningless and the process being managed by ongoing large liquidity injections into the overnight market, this appears to be a defacto move to a more quantity-based monetary policy, although not by traditional means. In addition to these actions we have seen the successful implementation of the first round of bank recapitalisations. This in itself is an important difference between previous attempts to stabilise the economy and the current situation.
It is also interesting to note that we are seeing a change in focus in the policy debate in government circles. Whereas policy had historically been predominantly demand focussed, there is now a growing focus on the supply side. Going forward we are likely to see more explicit policy support for capacity and employment adjustment. This is likely to reinforce what is already an important and growing trend at the company level. The structural adjustment will continue to be an impediment to growth in the short term but nevertheless improves the longer term outlook and confidence.
With all these factors coinciding for the first time in an economy that was already showing signs of stabilising, there has been a clear upwards shift in confidence, not just amongst equity investors, but amongst the managers and owners of small companies that are so important to Japan.
We expect to see some growth return to the Japanese economy in the first half of 1999, with the second quarter seeing the greatest impact from some of the shorter term-policy measures. However, as these wane we may well see some negative numbers in the second half and a flat year for 1999 overall. This still represents an upward revision on our existing forecasts. For the year 2000 we expect growth to remain low, but at over 1 per cent it represents another improvement on previous expectations.
Stock Developments
While the macro environment has improved, equally important but with perhaps more long-term significance is the restructuring of companies. While we have been focussed on this for some time, our confidence is growing that the process can accelerate, benefiting the equity market in aggregate.
There are several reasons why we think this process continues to improve and why more of the benefits can be retained beyond the fact that the number of restructuring announcements continues to grow. Firstly, there is a clear link between the macro environment and the ability for restructuring benefits to be maintained. With a weak economy last year, many of the companies that were making more concerted efforts to restructure were simply losing these gains due to the very poor operating environment. With our growing confidence that the Japanese economy is stabilising there is a greater opportunity for the benefits of restructuring to become more visible to the market.
More important however, is the improvement in the nature of some of the plans being articulated. Previously most restructuring plans in Japan have focussed on cost cutting within existing businesses without addressing whether capital should be allocated to the business. This question is now being asked, albeit from a low base. One of the results of this is the clear acceleration in capacity destruction.
There is also a notable broadening in the restructuring process. Many of the more adventurous announcements in the past have come from companies where the alternative to more concerted restructuring was failure. Recently we have seen more announcements of significant restructuring from stronger companies where it is not an issue of survival, but rather reflects a realisation that generating an adequate rate of return on invested capital is integral to being competitive in the longer term. The increase in merger and acquisition activity, particularly involving foreign companies is also an important sign of change.
Summary
As ever there are important risks around this process. Much of Japanese corporate management still has a long way to go and we will need to see this restructuring process spread. However momentum is developing which will be hard to reverse. It also is important to remember that BT and the market are trying to price a process that will take some time to deliver concrete results. That is, visibility of earnings will remain low for some time and sentiment and the risk premium will remain volatile. Nonetheless we are very encouraged by the improving trend in micro level change and are in turn seeing more stock opportunities.
Craig Stobo is BT Funds Management's chief investment officer
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