Market Review: 1984 Revisited for Japan?

To me, the Japanese election has many of the hallmarks of the massive sea change that New Zealand went through after the landslide win for Labour in 1984. That was a mandate for change and it would appear Prime Minister Koizumi has been given one now as well. Of course there are very good reasons why such a comparison is overly simplistic but I think what happened in Japan is potentially the most significant election outcome (from an economic stand point) to occur in the 21st century so far.

This is because Japan matters so much in a global economic sense. Depending on which measure you use Japan is either the second or third largest economy in the world, with of course the United States the largest. (China is second largest if Purchasing Power Parity is used rather than a straight conversion of a country's GDP into US dollars).

Japan is also New Zealand's third largest trading partner. However, Japan's contribution to the world economy has been sorely lacking in recent times, with it having the second lowest GDP growth of any of the major economies over the past five years. Note the lowest was Germany, another of the world's economic super powers.

This reinforces the reality that global growth has recently been left to the United States and to the increasingly significant contribution from the rising Asian super powers of China and India. So, is the baton about to be handed over from the US (which has such serious trade and fiscal imbalances) to Japan to make some of the running from here?

Yes, in the sense that the Japanese economy has been showing more signs of life over the past six months. This is even without the potential boost of a stronger Government influence also introducing positive change and momentum.

Japan's revised GDP for the second quarter of 2005 showed stronger growth than previously estimated, rising 3.3% (annualised seasonally adjusted) after a near 6% growth rate in the first quarter of this year. Not only were they solid absolute numbers but the composition was excellent, being a good mix of increased private consumption, non-residential construction and export growth. The previous reliance on Government pump priming the economy was notably absent with Public investment spending actually quite weak in the latest numbers.

There are other numerous indicators that the Japanese economy is finally on the rise again. These include:

- a jump in Tokyo land prices;
- a rise in bank loans outstanding;
- an increase in job to applicant ratios; and,
- evidence that industrial production capacity has bottomed.

All this has led ABN AMRO to suggest that "Japan might be close to the self-sustaining recovery that has eluded the economy for 10 years".

Moreover, the longer term outlook has been boosted by the potential for structural reforms, which the land slide victory has given to Koizumi and his Liberal Democratic Party (the LDP). In coalition it now has more than a two-thirds majority, enabling it to over ride Japan's upper house if necessary.

It has been given a mandate to make changes, the first of which is of course to reform and privatise Japan Post. The funds of Japan Post are mainly in low interest bearing accounts, which are sometimes used for funding unneeded infrastructural investments, which historically helped the LDP Party Curry favour with certain business interests. Koizumi is keen to stop this and while this is going to take many years, privatisation should eventually free up billions of dollars to be used in more productive investments, including the Japanese sharemarket.

There are many other areas for reform such as freeing up the economy from the bureaucratic sluggishness that often prevails in Japan. Other potential areas are decreasing the significant agricultural subsidies that still persist, introducing a consumption based tax and modernising the health sector.

Of course there are risks, with several negative factors that take some of the gloss off this potentially rosy picture. In the short term Japan is more vulnerable than most to any further oil price shocks, as it is a net oil importer. Its exports would also be hurt by any global down turn brought about by higher oil prices.

Japan is also running a substantial budget deficit (more than 6% of GDP). This is the result of previous (failed) attempts by Governments to use (inefficient) spending to boost the economy. The economy could therefore be hurt by the double whammy of tightening fiscal and monetary policy and this policy mix will have to be carefully co-ordinated.

In the longer turn Japan's demographic picture is not great as it potentially has more older people as a proportion of its population over the next two decades than most other developed countries. This is a direct result of its combination of low birth rates and little inward migration.

Electorate expectations are high after the landslide victory and this momentum must be maintained. Koizumi is saying he will retire next year, which could slow this. In addition, the New Zealand experience shows that restructuring does not come without social costs which may put some of the reforms at risk.

So what does this mean for the Japanese markets? Interest rates have risen over the last two years with ten year bonds more than doubling to now be 1.5% (obviously still very low by international standards). The Japanese sharemarket has been the mirror image to this, rising over 60% in the same period. Even after this rise the market still looks reasonable value with measures such as price/book and price/cash earnings still near 20 year lows.

Overall then the likelihood is that the Japanese economy and sharemarket will make a much more significant contribution over the next decade than it has over the past ten years - good news for the global economy and for New Zealand's as well.

Comment on the Month’s Numbers
It was a great month to be an equity investor, with the NZ market up 3%, Australia up over 6% and Europe up around 4% to 6%. The best of the developed countries was Japan, returning over 9% for the month and over 17% for the September quarter. In contrast, bonds fell, with overseas bonds outperforming domestic bonds by 0.3%.

To see how the numbers stacked up for various markets around the world in the past month and over the year, visit our Monthly Market Review here

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