Japan: Recovery for Real?


By Palash R. Ghosh On the eve of a crucial general election in Japan, many observers wonder if an apparent economic recovery can sustain itself. Japan's stock markets, after being stuck in a malaise for more than a decade, have rebounded and recently rallied to four-year highs. Thanks to reforms and trends in the country, a few managers of funds that specialize in Japan think this buoyancy can last.

For the last 12 months through Aug. 26, the average Japan-focused equity mutual fund rose 12.1%, vs. a gain of 10.8% for the Standard & Poor's 500-stock index. Over the three-year period, the average Japan fund registered an average annualized return of 11.9%, vs. 10.5% for the S&P 500. For the five-year period, Japan funds dropped 6.4%, compared with a 2.8% decline for the index.

In S&P's view, the quantitative evidence seems to support that the economic recovery in Japan is well under way. In mid-August, the Nikkei-225 stock index and the Topix index both reached roughly four-year highs. Moreover, Japanese GDP grew for a third consecutive quarter and is expected to rise 2.5% for fiscal 2006. Employment is also better. In June, the jobless rate dropped to 4.2%, a seven-year low. And consumer confidence, though still sluggish, may improve as more people have money to spend.

TARGETING DEFLATION. Mark Headley, lead manager of the $185 million Matthews Japan fund (MJFOX), believes Japan's recovery has legs. He thinks the country's central bank is intensely focused on ending deflation, which has been "extremely brutal on consumer-spending habits, on corporate balance sheets, and has brought their entire banking system to the brink of bankruptcy."

The bank's Governor, Toshihiko Fukui, "would rather risk some inflation than risk continuing deflation. This is most evident in the huge Tokyo property market, where we're seeing a broad-based turnaround and stabilizing prices. Hopefully, that spreads to the wider economy," says Headley.

The pace of corporate restructuring in Japan has also contributed to a brightening economic picture. "Corporations are streamlining, focusing on improving their bottom lines, rather than just the top-line," says Patricia Higase, co-manager of the Matthews fund. "With improved profitability and stronger balance sheets, companies have the free cash flow to pay down debt and increase operational efficiency."

KOIZUMI OPTIMISM. While annual GDP growth of just over 2% might seem modest, Headley says that as a very rich and mature economy, Japan doesn't need high GDP numbers to carry a sustained bull market, unlike Korea, China, and India.

Matt Hudson, manager of the $326 million American Century Global Growth fund (TWGGX), believes the real catalyst behind Japan's resurgence is optimism that Prime Minister Junichiro Koizumi will win the general election, thereby enabling the quicker passage of his reforms. "Although economic fundamentals are clearly improving across the board, this rally has been driven by, and will largely depend upon, how successful Koizumi is," Hudson says.

The Prime Minister called a snap election after the Japanese parliament rejected his proposal to privatize the state-run postal service. With about 350 trillion yen ($3.3 trillion) of assets in consumer savings and insurance deposits, Japan Post essentially functions as the world's largest saving bank. Unleashing this vast amount of money, which would then be reinvested into the economy, could spur further growth.

INSIDE PLAYS. However, Koizumi may face an uphill battle. Many members of his own ruling Liberal Democratic Party oppose the proposed sell-off. "If the election goes Koizumi's way, he can get the dissenters thrown out of Parliament, and, it is hoped, push his reforms through. The election is the galvanizing event in this rally," says Hudson (see BW Online, 9/8/05, "A Wily Koizumi Looks Set to Conquer").

One factor that he believes has contributed to the stagnation of Japan's economy -- cross-shareholding -- appears to be winding down, Headley says. This is a long-standing Japanese corporate practice whereby the management of one company buys significant shares of another company, often in the same industry. Big commercial banks, in particular, have participated in these deals. This tactic is seen as a defensive measure by executives to prevent hostile takeovers, but some investors think it really serves to diminish the influence of public stockholders.

Meanwhile, foreign buying of Japanese assets is accelerating, as international investors seek to participate in Japan's growth and purchase stocks that appear to remain inexpensive relative to those in the U.S. and Europe. Headley notes that in June, Japan became a net recipient of foreign direct investment for the first time ever. "Domestic pension money and global institutional money are going into Japanese stock markets, especially Tokyo property markets," Headley adds.

ENERGY THRIFT. Perhaps the greatest obstacle to a sustained recovery is the high price of crude oil, which recently touched an all-time peak of more than $70 per barrel before pulling back. Japan imports nearly 100% of its oil.

On the plus side, however, Japanese companies are extremely energy-efficient by necessity. According to data from Goldman Sachs, Japanese consumption of oil as a percentage of GDP "has declined substantially because companies have triggered a lot of energy-saving initiatives. This figure has plunged from 120% in 1970 to 52% in 2004," says Higase.

A key to the strength of Japan's economy appears to be its large and diverse financial sector. Japanese banks have restructured, cut their bad loans, and started to boost lending. Banks are particularly positioned to do well, since they are leveraged to an improving economy, Headley notes.

HOT SECTORS. As a stock-picker, he likes Japanese banks, brokerages, and insurance companies. "Financials are a good way for investors to participate in a restructured and reflated Japan," Headley says. "There's a lot of potential for growth here. Japanese consumers are one of the most underserved communities of wealthy people on the planet."

Higase is also bullish on Japan's technology and retail sectors, particularly the e-commerce business, a play on increasing consumer confidence. As of July 31, Matthews Japan had 33.5% of its assets invested in consumer discretionary stocks and 23.4% in financials.

Here are the top-performing funds focused on Japan for the last year, three years, and five years through Aug. 26.

Top Japan Funds, 1 year

Fund

Return (%)

DFA Invest Group Japanese Small Company Port (DFJSX)

21.7

ProFunds:Ultra Japan/Inv (UJPIX)

20.8

JP Morgan Japan/A (CVJAX)

17.1

T Rowe Price Japan Fund (PRJPX)

16.6

PIMCO:JapaneseStock+TotalReturnStrategy/Ist (PJSIX)

16.5

Average Japan Fund

12.1

S&P 500 Index

10.8

Top Japan Funds, 3 years

Fund

Return (annualized %)

DFA Invest Group Japanese Small Company Port (DFJSX)

26.5

Fidelity Japan Smaller Companies (FJSCX)

21.2

Matthews Japan Fund (MJFOX)

18.2

JP Morgan Japan/A (CVJAX)

17.2

The Japan Fund/S (SJPNX)

16.9

Average Japan Fund

11.9

S&P 500 Index

10.5

Top Japan Funds, 5 years

Fund

Return (annualized %)

DFA Invest Group Japanese Small Company Port (DFJSX)

9

Fidelity Japan Smaller Companies (FJSCX)

3.4

JP Morgan Japan/A (CVJAX)

-1.8

Matthews Japan Fund (MJFOX)

-3

The Japan Fund/S (SJPNX)

-3.1

Average Japan Fund

-6.4

S&P 500 Index

-2.8

Ghosh is a reporter for Standard & Poor's Fund Advisor


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