More on China…and the “Flaw” of Capitalism

If you create a graph of the MSCI China Index the past 10 years relative to Japan’s Nikkei over two decades ago, it’s not surprising to see a close relationship. The difference this time is the Chinese government stepped in to prop up prices soon after markets collapsed, thereby prolonging the life of the domestic property bubble. If equities are a reflection of the health of corporate China, then China will need to face reality soon enough. After rebounding over 120% in early 2009 from the trough in October 2008, China share prices have gone nowhere. It is true most Chinese consumers are enjoying higher wages, but the cost of living has certainly risen. I doubt the government’s CPI comes even close to reflecting the change in household costs. What matters even more is whether Chinese companies can continue to pay the higher wages. Equity investors seem to be skeptical. It’s becoming more and more difficult for Chinese authorities to keep promoting the dream of a strong and vibrant economy. Sooner, rather than later, they will need deal with the associated economic costs of a prolonged period of strong growth such as overstretched balance sheets, inflated property prices and widespread corruption.

It makes you wonder if one reason capitalism seems to be flawed of late is because governments around the world keep on intervening with stimulus packages to prop up their economies whenever there’s a recession. They want to be seen as doing whatever they can do to revive their economies. The problem is a period of private sector “irrational exuberance” will always result in a painful recession. Whether the recovery is “V,” “L,” “U,” or “W” shaped doesn’t matter. The pain is the same. Maybe the best medicine government leaders can provide is only a combination of safety nets, “proactive” monetary easing and corporate bailout packages that uphold market principles. Instead of rushing out to unveil “exuberant” fiscal spending packages, governments should only be allowed to use policy options to support their economy in times of economic duress.

It’s human nature to get swept up in the pool of “greed and arrogance” that appears when economic times are good. The problem is that in “bad times,” it continues. Behind excessive and misguided government pump-priming are layers and layers of cronyism and political lobbying. That’s the real reason capitalism is flawed in the current day and age. We can not turn the clock back to fix past mistakes. The problem now is whether the mistakes are too big to fix going forward. With all the economic problems the world faces (China’s bubble bound economy and US-Japan-Europe fiscal quicksand), will policymakers have the patience and wisdom to set things straight. I would honestly hope so, but in the race to grow and succeed, the only real choice, a “global hard landing,” will be avoided at all costs until…

Reading List

• 5 CHARTS OF CHINA’S GROWTH CONUNDRUM - Pragmatic Capitalism

• THE CHINESE BLACK BOX & A WARNING SIGNAL? – Pragmatic Capitalism

• China Housing Boom Spreads to Smaller Cities, Posing Dilemma - Bloomberg

• China’s riot town: ‘No one else is listening’ – CNN

• China’s bubbly property markets have not burst. Yet – Economist

• China Property Developers’ Outlook Cut to ‘Negative’ by S&P – Bloomberg

China Bears: Soros, Roubini, Chanos, Magnus and Majority of Investors

The bearish call is growing louder and louder on China. Regardless of all the potential growth hidden in the Chinese economy, what is of concern is the method in which growth has been created to date.

Roubini points out that fixed investment in China is now around 50% of GDP. He says, “Down the line, you are going to have two problems: a massive non-performing loan problem in the banking system and a massive amount of overcapacity are going to lead to a hard landing.” This sounds quite familiar. Consumer spending as a % of GDP continues to shrink in China given the rapid growth in fixed capital investments. When the global economy falters, or the property bubble bursts in China, a hard landing will be unavoidable. I do not see how the economy will have a solid domestic foundation established in time!

At an Oslo conference, Soros commented that he thinks China is setting itself up for a “hard landing,” as the authorities are “losing control.” He said, “China’s formula for steering its economy is “running out of steam,” adding the country is seeing the beginnings of wage-price inflation.” Personally, I never thought China would be able to control inflation. I felt the pace of real tightening would end up being far too slow to hold down prices after the massive $586bn (15% of GDP) pump-priming package was released in 2008.

We all know Chanos’ view on China. Chanos said in May “I am not bearish enough on China.” A comment in his Bloomberg interview that stood out was “…If you look at the balance sheets of the developers, you’d be hard-pressed to see how healthy they were because they are all loaded up with land, just as our developers were at the top of our market… They are drinking the Kool-Aid, so to speak.” Pushing the country to meet growth goals by hastily constructing high rises and apartments; building resorts and shopping malls that look like ghost towns; and laying out roads and bridges to nowhere will certainly create a mountain of NPLs that will break the banks.

Back in December, George Magnus, of UBS, was interviewed by Fortune Magazine and discussed his new book “Uprising.” He commented, “There will be issues like inflation that will test the leadership there on their willingness to change. I am not holding my breath for any big gestures or radical economic changes.” It’s a book worth reading. Consumer price inflation is closing in on 6% in China. If the country wants wage growth to continue in the double digits without inflation being an issue, it’s impossible.

Overall, investors and economists are concerned China’s future may not be as bright as it’s made out to be. I agree. It’s a matter of time. Whether one predicts the crash to come in 2012, 2013, 2014 or beyond, a negative catalyst is required. Will it be the power shift in 2012, rapid inflation or a global crisis? No one knows for certain. What we do agree on is a hard landing is increasingly likely, and not the other way around.

Quotes taken from the follow readings:

• Soros Says China Missed Window to Stem Inflation, Now Risks ‘Hard Landing’ -  Bloomberg (Jun 14, 2011)
• Roubini Says ‘Perfect Storm’ May Threaten Global Economy – Bloomberg (Jun 13, 2011)
• CHANOS: I AM NOT BEARISH ENOUGH ABOUT CHINA – Pragmatic Capitalism (May 24, 2011)
• China Will Face Crisis Within 5 Years, Investors Say – Bloomberg (Jan 26, 2011)
• Four questions with China skeptic George Magnus – Fortune (Dec 3, 2010)
  

Interesting Readings: US Default – China Hard Landing – Ice Age

If America is worried about its fiscal debt, the chart by the Congressional Budget and Policy Priorities (CBPP) makes it clear what needs to be done. The government can start by ending tax benefits for the wealthy. (read more on the subject at Chinese Rating Agency Says “The US Has Already Defaulted” … German Rating Agency Downgrades U.S. Debt – The Big Picture)

If there is a hard landing in China, the US will be blamed I imagine. In any case, the hard landing scenario for China has been forecast for years. Eventually it will happen. It seems as the years pass by, the odds keep building.

• China Risks ‘Hard Landing’ on Excess Investment, Roubini Says – Bloomberg

Why I disagree with the Japan analogy for the US can be found in this post (No Country Compares to Japan!)

• THE ECONOMIC ICE AGE – Pragmatic Capitalism

Bubble unwinding or rewinding…

There are various views on who the culprit is behind the jump in global commodity prices. The most popular one is commodity prices are surging because of strong demand in China. In 2008, some Fed officials were quick to point out that loose policies in emerging economies allowed those countries to grow too fast. Now, since the US is dependent on global growth, the Fed’s lips seem to be sealed. When it comes to economies, whether developed or developing, growth or inflation all need to have a catalyst, and that tends to be money.

In the days when monetary policy was expected to provide leadership to markets, the Fed would always start to tighten whenever growth turned up. They acted in anticipation of higher prices. Economies expanded and shrank along with the business cycle. Then Greenspan ushered in a new era of monetary policy. This allowed the bull market to keep on running. Any time US production recovered, Greenspan decided he could wait a couple of years before hiking interest rates. He saw inflation as a “benign” threat. In 2002, when production started to improve, the Fed stayed on hold and even eased for whatever excuse there was at the time. The correlation between the CRB index and Fed Funds rate broke down dramatically as the commodity “bull” was let loose. There were bubble warnings everywhere, but policymakers paid no attention. When the crash of 2008 came, the US lost it’s role as the world’s economic leader. Now the world lacks a leader, so it seems.

The starting point of the problem of extremely high commodity prices was arguably the insatiable appetite of the US consumer. One thing led to another. China grew and grew. What can be said is the strong US economy helped cure Asia’s financial problems and provided plenty of demand to go around. Now with appetites as large as they are on a global scale, probably the only way for commodity prices to fall back to past levels would be for the world to sink into a deep recession. If that happens, maybe the relationship between the Fed Funds rate and the CRB would reestablish itself. Let’s hope not as the gap seems far too large…

There are concerns Asia is moving too slowly in hiking interest rates. I happen to agree, at least for China. However, as mentioned earlier, Asia is not the real culprit. The largest economy in the world, the USA, allowed rates to stay negative for way too long and is still letting real rates sink. Either this is good news or bad news for the economy down the road. I would side with the latter.

Related Articles:

• America’s Own Lost Decade – CNN
• PAUL KRUGMAN & RICHARD KOO ARE BOTH WRONG - Pragmatic Capitalism
• BERNANKE: I DIDN’T DO IT! – Pragmatic Capitalism

The Multitude of Risks

We will always live in a world full of risks. We have the choice to get caught up in them, block them out or calmly settle somewhere in between. Among investors, there are those that still choose to focus on the risks and refuse to place any bets. Then there are the “greedy” investors who keep loading up on their winners, paying little heed to risks lurking around the corner. The best investors, however, are risk managers at heart with an innate ability to maneuver through the noise and decide what risks matter now, in the future or not at all.

Despite all the education and training, most investors do not place first priority on managing risk. If they were, we could probably invest in any fund and know the odds are high we would come out on top. However, that’s not the way it works. Investors have their own styles, models, processes and methodology for managing risk. Despite all the systems, checklists and deep research, the majority of investors concentrate on how their ideas will make money and not on how much will be lost.

I often read about investors, hedge fund managers in particular, talking about how they like to add to their winners. It sounds good. Just think, though, the more an asset price goes up, more investors are piling in until the only choice left is to exit. No matter how good an investment may be, what also matters are who is buying and why. Instead of talking about the price, I would be more impressed if investors paid less attention to the price and more to how they would value the investment. There comes a level in every investment, short or long, where the majority of investors, regardless of style or system, decides to sell. That’s why it’s important to try to understand what most investors are thinking, their risk appetite and time horizons. Often times, the most important decision an investor makes is the “sell.”

Instead of going over what I think the major risks are out there, as the odds are we are all thinking along the same lines these days, I thought David Rosenberg sums it up well with ”THE 7 MAJOR RISKS BREWING – Pragmatic Capitalism.” What differs among us is the odds we would place on each major risk looming over markets and economies.

Below are my thoughts:

China economic crash – I think it is inevitable that one occurs but for that to happen either the global economy must be heading for a recession or asset prices in China need to be collapsing. Odds will increase from 2012 on, but we are not there yet. (Current Risk – Low)

Ongoing sovereign credit risks in Europe – This story will likely sound like a “broken record” for some time given the less than robust recovery we are witnessing on a global scale. The solution for the EU is either a strong global economy or a breakdown of the EU. As a result, what we have to look forward to is one rating downgrade after another… (High)

Strengthening US dollar – Given the outlook for Europe and rising chance of tightening in the US, the dollar looks to have changed trend for the latter stages of the business cycle. (High)

Painful recession in Japan – The recovery is just getting started, and I expect it to gather momentum as private and public capital investment pick up. The key for Japan is whether confidence is recovering. Moreover,  how earnest will be the effort to fix Japan this time? Instead of worrying about all the problems, will they “do something?” I think they will. (Moderate to Low)

Messy US fiscal policy – The debate will get very hot and stones will be cast. What most voters want are jobs and security. Squeezing the life out of the economy when the recovery has little life to spare will not go over well. In the end, politicians will have to settle for less austere programs. Of course, it’s all politics, which is about as reliable as the weather forecast. (Moderate to Low)

Fed tightening shakes the markets – That of course depends on the global economic recovery. I doubt the FED will tighten if growth in the rest of the world is faltering. The odds are economies get a second wind before the FED decides to switch gears. For correlations to be of significance, they need to have a time scale of at least 5 years…(Low)

Indicators are suggesting the US economy is recession bound – Following a major disaster in Japan, tightening in China, shaky economies in Europe and high commodity prices forcing the private sector to tighten wallets, it’s no surprise to see growth momentum slowing down. The drop in oil prices should come as a relief, and I still consider China to be behind the curve. With corporate cash levels high, earnings growth remaining strong and global policy still highly conducive to growth, I consider any slowdown in growth near term to be temporary. (Moderate to Low)

Confidence among investors is a little shaky at this stage in the cycle as markets adjust to an environment where policy is certain to be favorable to one where tightening is necessary. What it comes down to in the end is whether earnings are holding up. As it stands now, they are, and the odds are they will remain that way for a few more quarters. While sticking with defensives is understandable, given the level of uncertainty pervasive in markets, it’s still too soon to make the big switch. As some defensive sectors have performed relatively well the past few months, it may actually be time to cut back on positions.

Related articles:

MARKET MINUTE – A GLOBAL SLOWDOWN? - Pragmatic Capitalism

Sector Performance Since QE2 -  The Big Picture

Just a Healthy Correction – Add to Cyclical Value

With the Dow falling -3% from its peak in August and the dollar up over 3%, some market participants are starting to fear the bull market is over. Adding to these concerns is the fact commodities are getting slammed due to either a stronger dollar, CME margin hikes and expectations for a global slowdown. Oil has lost around -15%, silver -30% and gold -4.5% from their peaks. Is now the time to be bearish?

What really determines asset prices? In addition to secular or cyclical factors supporting asset prices, speculation and risk parameters influence prices. Until the end of April, it was widely accepted that policy in the US would remain easy for months to come. Speculation seemed to keep growing and growing. Some perma-bears became bulls and even a “new paradigm” for oil was declared. On April 27th, the Fed said it would start to cut liquidity, beginning with an end to the $600 billion bond-buying program in June. Investors knew it would happen at some point, but they still “sell on the news.” Fed officials also recently discussed how they would tighten policy (comments from Fed’s Bullard in a April 29th WSJ article). Around the same time, the CME started raising margin requirements for silver and later did the same for crude oil, gasoline and oil products. As a result, many investors had no choice but to cover positions.

Despite the sell-off, have fundamentals really changed? From a cyclical standpoint, the course of the global recovery has not altered much in the past few weeks/months. While temporary slowdowns are expected in some parts of the world either due to the March 11th Japan earthquake and/or higher oil prices, they are only “temporary.” Production may hit a couple of bumps and hiring could take a pause but that doesn’t necessarily suggest the economy is recession bound. Policymakers will not rush to tighten when unemployment remains this high. Moreover, if the threat of rapidly rising commodity prices is taken out of the inflation equation, even more reason policymakers will take their time. As for risk parameters, the overall picture hasn’t really changed. From interest rates, currencies, markets to politics, market participants remain concerned over fragile recoveries around the globe.

If it’s not fundamentals or a dramatic change in risk factors, the real reason for the equity market correction must be speculation is being squeezed out. Looking at the closely watched US ISM mfg. index, it stood at 60.4 in April, the second month in a row it declined. The primary reason behind the drop was slowing production. This may continue for a few months but we must also remember demand in Asia remains strong. In the end, it’s highly possible the ISM mfg. PMI bounces around 50 to 60 as it did from 2004 to 2008. If that is the case, the S&P 500 could keep heading higher, easily breaking 1400.

The chart below on the “Factors Driving Asset Prices Across Market Phases” shows we are somewhere between a “bull market” and “Peak” but I wouldn’t say, “greed and euphoria” is setting in yet. Again, we are most likely just witnessing a healthy correction, one that will last until speculation dies down and fundamental data lifts expectations again.

The last chart I created from information used in a Japan Topix macro sector model I made years ago. Sector relative performance was tested then and the results are what you see in the chart. Whenever output is rising and the market is reasonably well valued, the majority of market participants tend to prefer cyclical value plays (late cycle), such as consumer discretionary, basic materials and industrials. When the business cycle peaks, investors switch to absolute hedges, such as utilities and consumer staples. Despite the recent market sell-off, we are not there yet. Based on the chart, one should be more selective with tech and telecom. Cyclical value plays continue to look attractive, given the potential for output growth to remain strong.That said, one may also want to start making a very selective increase in defensive value names, especially if one needs to reduce performance volatility.

Related article:

USING THE ISM CYCLE TO INVEST

Japan Update: Recovery underway already? – TSE Screen

Now that was a surprise. Despite the disastrous earthquake in Japan and all the plant shutdowns and power outages, machinery orders in March actually rose 2.9% versus expectations for them to sink -9.7% mom. The numbers were released Monday. Hitachi Construction (6305), the world’s largest maker of giant excavators, is already expecting to be back to full capacity this week. Against expectations, private capital spending is bouncing back very quickly in Japan.

Other economic events this week will unlikely be as encouraging but most markets participants are already expecting the worst. The March Tertiary Index, announced on Wednesday (18), is expected to post a -5.7% decline. The January to March real GDP figures come out on the 19th and economists are forecasting a -0.5% QoQ drop or -2.0% annualized. The real question is whether the economy, starting from April, will bounce back. If the March private machinery orders are any indication, the likelihood for a quick recovery looks encouraging.

The Japanese government expects the earthquake will take -1% out of real growth in 2011. That seems reasonable but it may turn out to be less. In the past, one would typically expect Japan’s recovery to be export led but with plants needing repair, government packages being spent and the overall country looking to rebuild, I wouldn’t be surprised if the recovery is domestic demand led this time. Along with the GDP announcement, the BoJ will be holding a two-day meeting at which the BoJ will likely vote to wait and see.

Interest rates in Japan are already low but the problem is companies and consumers refuse to borrow. They may now be forced to change their view on debt. The money supply and bank lending figures tend to go unnoticed but last week they shed a positive light on the economy for a change. Japan bank lending growth may continue to fall but the rate of decline has gone from -2.0% in Oct-Dec, -1.8% in Jan-Mar to -0.9% in Apr. The largest change actually came from city banks. The question is will this continue. I would place the bet on “yes.” It’s true Japanese companies are sitting on a record level of cash but we are talking about a nation that was affected by the Great East Japan Earthquake. When there is no guarantee to how long the global economy will continue to recover, would it be smart for Japanese companies to delve into their cash holdings when banks are offering loans at near zero percent?

The bottom line is keep an eye on capex and liquidity in Japan. The recovery has started.

On a separate note, I thought it would be interesting to provide information on Japanese equities. I realize last week was the peak in earnings announcements but there are a few left. Next week companies to watch will be:

• 5/16 8306 Mitsubishi UFJ, 8282 K’s Holdings, 6503 Mitsubishi Electric
• 5/17 1379 Hokuto
• 5/20 8795 T&D Holdings

Very thin list of companies as you can see. Last week there were 2,156 companies announcing results compared to only 209 this week. One that stands out is K’s Holdings. The company is an electronics retailer based in Ibaraki, the prefecture just below Fukushima.

This Week’s Screen Parameters

This week’s screen using http://www.kabumap.com data takes into account the following parameters.

• Market cap min. 70 billion yen
• Trading volume min. 250 million yen
• 1 month change min. 0%
• PBR max. 2
• ROE min. 10%
• Dividend yield min. 1%

The screen yielded only 27 companies!

Companies that look interesting are 5949 Unipres, 9831 Yamada Denki, 8282 K’s Holdings, 6501 Hitachi, 4042 Tosoh, 9433 KDDI and 7453 Ryohin Keikaku

Important News: Fed rate hike call; Toyota Japan; Asia HF inflows; Strong China

The Fed’s Kocherlakota is the first FOMC policymaker to suggest there may be a rate hike by year-end, based on his economic outlook. He expects economic growth to improve to 3-3.5%, the unemployment rate hover between 8 and 8.5% and core inflation rise to 1.5%. Note that his unemployment call is slightly more optimistic than the Fed view. What’s obviously important are the job figures. So far, it’s been far too fragile a recovery on that front. If we see a marked improvement in the months ahead, the rhetoric at the Fed will obviously change in favor of tightening. The clock is ticking and market participants are starting to look out 3 to 6 months.

• Fed’s Kocherlakota sees case for late-2011 rate rise – Reuters

Toyota, as one of the leading Japanese corporations, plans to build more cars in Japan. One would think the Great East Japan Earthquake would convince Japanese companies to keep shifting production overseas. As I suggested in my previous blog post, Japanese companies may decide to build more plants in Japan. It will be interesting to see how Japan’s plant and equipment investment plans play out in the quarters ahead.

• Toyota Doubles Down on Japan – Bloomberg

Asia hedge funds saw $3.6bn of inflows in Q1, bringing the total to $88.1bn, the highest since the $111.4bn peak in the spring of 2008. China/HK has 26.3% of Asia hedge funds, the US fell from the top to 24.87% and Singapore is third with 13.49%. 74% of the Asia hedge funds are equity long-short, RV 14%, event 7% and macro 5%. Hedge funds globally saw an inflow of $32bn.

• Asia hedge funds net record quarter inflow of $3.6 billion – AsianInvestor

The consensus of 19 economists foresees China growing 9.5% in 2011 after posting 10.3% growth in 2010. Moreover, now they expect inflation to be “sticky” in China with the government taking all kinds of steps to control inflation. It was only a month ago economists expected inflation to peak as the central bank had inflation under control.

• China 2011 growth seen solid, inflation to quicken: Reuters poll – Reuters

Japan’s Future – Hope at Last

The View Then? When former PM Abe and the LDP’s old guard began to backtrack on structural reform in 2006, it was clear Japan was reverting back to its old habits. As the recovery gained momentum and the banking crisis subsided, Japan became complacent and averse to “change.” The government felt there was no longer a need to pressure corporations to restructure, as it meant more layoffs, plant closures and bankruptcies. Despite what investors were demanding, Japan, as a nation, decided to bury structural reform. In the years to follow, profitability stagnated, jobs failed to be created, liquidity growth slowed and deflation worsened.

From a global standpoint, I felt Japan Inc. lacked the strategic know-how to make any meaningful headway in an extremely competitive global market. Developing economies were rapidly catching up to Japan. For investors, it was as if Japan no longer mattered after the government backtracked on reform. At best, Japan was a source of liquidity. The view was  Japan’s mounting national debt would slowly get the best of it and that was it. Japan was looking like a nation without a future. There was no hope.

Now, after 5 years, should I change my view? For Japan to ever stand the chance of achieving a self-sustainable recovery, there are two important factors that need to be in place. First, Japan needs corporate profitability to be on a steady improving trend and for standards to be raised. Currently TSE1 ROE stands at only 6.9%. Having Japan Inc.’s ROE rise above 10% would be a start. Another sign that Japan would be on the right track would be to have liquidity growth exceed 5%. It now stands at 2.7% and the last time Japan saw more than 5% money supply growth was in March 1991. Since Nov 2009, loan growth has continued to shrink around -2% YoY as companies are reluctant to borrow. That said, bank lending may receive a boost from the reconstruction of East Japan. Companies will also need to expand investment and consumers will likely look to reinforce their homes.

Will Japan Inc.’s aversion to increasing debt ever end? If it does, we can certainly expect liquidity to take a turn for the better and the same for Japan Inc.’s ROE (Dupont Formula: ROE= Net income/Sales X Sales/Total Assets X Total Assets/Average Shareholder Equity). If Japanese companies were to increase their debt financing, i.e. leverage, ROE most likely will start to rise. The problem with Japan’s ROE is Japanese companies have avoided increasing debt like the plague. We can not expect Japanese companies to suddenly wake-up and see the need to improve profitability by taking a more proactive approach to corporate restructuring. It’s just not the “Japan Way.” However, if there is a reason for Japanese companies to increase their leverage, it’s now, following Japan’s worst natural disaster. That’s probably the only near term way to make a meaningful improvement in Japan’s return on equity.

So is now the time to Buy Japan? Prior to March 11, when you thought of buying Japanese equities, you were likely thinking about the global recovery and how Japan would benefit. However, the yen kept on strengthening and the government was falling apart. It was hard for investors to be convinced to overweight Japan. Most investors actually gave up on Japan long ago and were either sitting on the sidelines or only in for the trade. No longer was Japan’s role in the global recovery considered that significant. In years past, if the US started recovering, the assumption was the same would hold true for Japan. The relationship was clear in the correlation between the Nikkei and the S&P 500. That trend started to break down in 2009 after the Lehman Shock. Japanese equities were no longer able to keep up with the US. At least one of the many reasons for the correlation collapse was a strong yen and the negative earnings repercussions associated with it, especially when a global recovery was driving growth.

Despite the breakdown, the Nikkei still gained around 48% from the trough in March 2009 to before the Great East Japan Earthquake disaster hit. In addition to the global recovery pushing up Japanese equities, deflationary pressures were subsiding, capital investment recovering, while employment conditions and consumer spending were slowly getting better. Thanks to the global economy, Japan was enjoying a cyclical recovery again. Nevertheless, there were few investors who were expecting “growth” to be enough in Japan to convince them to change their allocation to “overweight.” After so many false hopes, seasoned investors found it hard to believe Japan would enjoy a full-fledged recovery. Eventually, the recovery would end and the likely scenario would be that Japan would fall back into a deflationary trap.

What’s different this time around? I know, expecting something to be different in Japan may be a little over optimistic. Also, hoping for the yen to weaken, seems pointless. However, that’s what Japan may just get in 2011. The US will definitely need to tighten policy ahead of Japan. Also, Japan’s trade balance is about to turn into a deficit for months, if not quarters. More importantly, something else that is different in Japan is a newly found sense of national pride that seems to have swept the nation. Yes, the fear and shock of the earthquake disaster will linger for some time. But, from the pain, Japan seems to be regaining the “Confidence” that it lost the past two decades. This is a very important development.

Reasons to Buy Japan:

Global recovery:

• Yes, there will be negative repercussions from the Great East Japan Earthquake on profits, production and employment in the quarters ahead, but they will not alter the course of the global recovery.
• Japanese exports may continue to suffer for months but overseas production adjustments will likely be made to pick up the slack.
• China continues to be too slow to tighten as it seeks to avoid a crash. The result is inflation remains a risk and growth in China will keep running at a fast pace.
• Relatively loose global policies will support overall demand. Some economic recoveries around the globe will pick up momentum as earnings filter into the real economy through increases in hiring and private investment.
• Risks: Higher oil prices will lead to market corrections and tighter consumer wallets. Inflationary pressures could take off and force policymakers to tighten sharply.
• Ideas: 7203 Toyota, 7201 Nissan, 7751 Canon, 5201 Asahi Glass

Weaker yen:

• In the near term, Japan will face stepped up inflows from companies repatriating overseas funds. In addition, investors will continue to shun the US dollar as they are confident the Fed will stick to its extremely easy monetary stance. However, as months pass, there will be even greater demand for imports of energy and food in Japan. Together, they make up 42% or total imports.
• At the same time, exports will be weighed down by lingering radiation concerns and plant shutdowns. As a result, the trade balance is bound to run into a deficit and it may take quarters for this to reverse. Gradually, upward pressure on the yen currency will diminish.
• The Fed will have to succumb to the threat of higher inflation. Investors will start to prepare months in advance.
• Japan’s zero rate policy is here to stay for some time.

Reconstruction: Government estimates put the damage at costing over $300bn to clean up, rebuild towns and provide temporary facilities. S&P estimates it could go up to $600bn.

• Idea: 6301 Komatsu
  

Health and Welfare: Given the concerns over nuclear radiation, loss of electricity, communication failures and health risks, the following themes are certain to play out.

• Expansion of medical services – 4502 Takeda, 4543 Terumo
• Clothing to combat heat or cold: 9983 Fast Retailing
• Water purification: 3405 Kuraray (activated charcoal)
• Telecommunications: 9437 NTT Docomo

Decentralization: The government will now need to push decentralization and greater regional development even more given the mounting risks associated with the possibility of a major Tokai earthquake.

Capital Investment: Companies will need to reinforce existing plants or build new ones in different locations to make sure supply and distribution lines do not break down as they did after the Great East Japan Earthquake. While it may entail some companies deciding to shift production overseas, there are plenty of regions in Japan that also look reasonably attractive.

Solar Power and Alternative Energy Sources:. Following weeks of electricity outages in Japan, homeowners are more likely to pay to have solar panels installed to make sure there is less risk of a blackout in the future. Knowing Japan, it may well become a fad. While the need for nuclear energy will not disappear, the dangers surrounding nuclear power have been brought to the forefront after the Great East Japan Earthquake. As a result, there are plenty of reasons why companies and governments will make a greater effort to explore alternative sources of energy in the years ahead.

• Ideas: Solar – 6753 Sharp/4118 Kaneka and wind and hydraulic power – 6361 Ebara

All of this will lead to greater “growth,” and yes, an end to deflation. For years I’ve been bearish on Japan. I felt the government lacked leadership and this hasn’t changed. I also didn’t believe corporate Japan would be able to improve profitability to the extent where jobs would be created and deflation would end. However, the problem with Japan, in addition to low profit margins, is the private sector has been reluctant to increase borrowing for far too long. Why? Deflation expectations are hard to overcome, especially if they have been around for 20 years. If we start to see a significant improvement in bank lending and money growth, there will definitely be a coinciding shift in price expectations. This “change” will lead to increasing borrowing, stronger growth, higher prices and guess what, a “virtuous cycle.”

Have a look at this slide show ”10 Things to Emulate from Japan.”

Stock Idea list

Related Articles

• OECD slashes Japan GDP forecast on quake – Reuters
• Rebuilding Japan—or ruining it - The Economist
• BOJ Shirakawa warns Japan economic outlook “very severe” – Reuters

Precursor to a View Change on Japan

Anyone who has ever read any of my Japan blog posts or research reports since 2006 will be aware of my rather bearish stance towards Japan. The last time I turned bullish on Japan was in early 2003. When reform died though, so did the potential for a self-sustainable recovery.

After the Fukushima earthquake tragedy, I chose not to write about Japan. The near term negative repercussions seemed to be far greater than anyone could imagine. Last week, it was announced March industrial production plunged -15.3% MoM but the good news was companies expect production to pick up in both April and May. That may well change for the worse though, given conditions have yet to stabilize. Meanwhile, consumers slashed spending the most since 1998 in March, as retail sales fell -8.5% YoY. That comes as no surprise given the electricity outages and the shock from the earthquake. The question is when will the rebound in the economy come and will it turn into a sustainable recovery.

This week is Golden Week in Japan, when Japanese choose to take their spring vacation. It appears Japanese people are taking a much needed vacation. According to the media, the number of Japanese going overseas is 2.5 times more than the previous year! The stress build up and lack of spending in March are cited as two reasons behind the sharp increase in overseas travel. While it definitely sounds encouraging, it is too early to be convinced Japanese consumer spending is bouncing back.

As you saw on television, Japanese citizens were quick to return to going about their daily lives but deep down, I can’t imagine how hard it must be to shake off the shock and despair of the earthquake/tsunami. There is also lingering fear over possible nuclear radiation leaks from the Fukushima plants, especially when you can’t trust how the nuclear crisis is being handled by the government or Tepco. Japan is a country that continues to be run by a leaderless government and the sad news is this won’t change any time soon.
What’s even worse is the looming threat of a major Tokai (Tokyo) earthquake. After the Fukushima disaster, Japanese people must be even more afraid. What’s important is how Japan reacts to this “new fear.”

Anytime Japan faced a crisis in the past, the government and corporate Japan sought “change.” What followed was progress on structural and/or economic reform. Will this crisis and “new fear” encourage the government and corporate Japan to change?

A natural disaster can’t be predicted but Japan can take steps to provide better protection for its citizens and buildings, as well as establish back-up plans for company production and distribution lines. Thus, while plenty of money will definitely be required to reconstruct disaster stricken Fukushima and towns along the east coast, Japan will also need to spend more to protect themselves in the event of an even greater natural disaster in the years ahead.

What does this mean for Japanese markets?…That’s coming up next.