Good luck with your Japanese stocks

Business Times - 02 Jun 2009

JAPAN is booming, hot, going places, an oasis from the global crisis. One might be excused for believing that's true with a cursory look at the stock market. The Nikkei 225 Stock Average has jumped 30 per cent in the last three months alone. That might be fine if not for a deepening recession and the steady return of the deflation that Japan thought it had finally defeated.

Bubble, anyone? Well, yes. Analysts predicting a big earnings rebound in late 2009 or in 2010 are ignoring an underlying economy that is contracting at a record pace.

Things in Asia's biggest economy will worsen before the 'green shoots' supposedly sprouting around the globe take root there. There are some positive signs that are engendering a false sense of optimism. Japan's industrial output surged 5.2 per cent in April, the most in 56 years.

Some economists took that as evidence the world recession is easing. And then there was last week's victory by Steel Partners. The fund run by US investor Warren Lichtenstein won shareholder support to install a new board at Aderans Holdings Co, blocking a rival bid for control of Japan's largest wigmaker. It was a rare win for shareholder activism. The bigger picture is far less comforting. Never mind long-term crises such as debt and demographics, neither of which is remotely being addressed at the moment. Consider a shorter-term problem: price trends.

Consumer prices, excluding fresh food, declined for a second month in April. The 0.1 per cent drop was modest, yet it fits with other evidence that weak global demand is chipping away at household and business confidence. Tokyo-based analysts such as Takashi Nishimura of Mitsubishi UFJ Securities Co aren't exaggerating when they say 'this is the beginning of the deflationary period in Japan'.

Actually, an argument can be made that Japan never defeated deflation, regardless of the spin coming from the government and the Bank of Japan (BOJ). It took record increases in food and energy in 2008 for Japan even to register modest inflation. The price pressures that did bubble up were more about the global economy than anything that Japanese policymakers did.

The BOJ's 'quantitative easing' policies, the ones now being employed by the Federal Reserve, helped stabilise the economy. What they didn't do was repair Japan's malfunctioning credit system. No matter how many yen the BOJ prints, there is little demand for borrowing and negligible interest in lending.

'Japan is facing the same problem as during the first half of the decade, when nominal interest rates hit zero, but this was still too high,' says Richard Jerram, chief Japan economist at Macquarie Securities Ltd in Tokyo. 'This is again the situation.' Mr Jerram's view is based on the so-called Taylor rule, which recommends lowering the benchmark interest rate by a certain level if unemployment rises and inflation decelerates. The return of mild deflation isn't a surprise. Core prices will slide 1.5 per cent this fiscal year and one per cent in the next, the BOJ's policy board forecast last month.

That's likely to prove optimistic amid weak growth and a leadership vacuum in Tokyo that has politicians distracted from the economy. The strong yen isn't helping. It is diminishing the value of overseas sales of exporters, including Honda Motor Co and Canon Inc. The yen's brawn is among the odder side effects of the financial crisis. No matter how ugly the economic data get, the yen stays strong thanks to the United States' mounting woes.

Speculation that the US may lose its AAA credit rating is bad news for officials in Tokyo. It just means the yen will remain stronger than they would like for the foreseeable future. Here, it is worth considering the events of 1989 and how they relate to Japan today.

That year was a fascinating one historically: the Tiananmen Square crackdown; the fall of the Berlin Wall; the death of Japan's World War II emperor, Hirohito; and detente between the US and the Soviet Union. This year also marks the 20th anniversary of the beginning of the end of Japan's bubble economy.

It was in December 1989 that the Nikkei reached its record of almost 39,000. It was also then that former BOJ governor Yasushi Mieno began raising interest rates, helping to precipitate the 'Lost Decade'. Rather than take policy steps to shore up the financial system, Japan opened the fiscal and monetary floodgates. Massive government stimulus and free money only got Japan so far in the 1990s and early 2000s.

When growth did return, it was more a matter of strong global demand than domestic events. Now that the world economy is in recession, Japan's economic playbook is no longer of use. The Nikkei is now at 9,522 points, a shadow of its 1989 high. And deflation is returning. If you see that as a reason to buy Japanese stocks, I wish you the best of luck.