Despite the prospect of a sustainable recovery, Japanese equities underperformed in the wake of the Livedoor scandal, although a market bounce and increased consumer spending augur well.
Japan's economic recovery is proving to be broad-based, with the upturn having spread to different parts of the economy. And in our view, it is sustainable. As a result, the recovery looks different from the false dawns of the 1990s and offers more encouragement to investors. However, the Japanese equity market has delivered a disappointing return this year, despite this benign domestic economic backdrop.
The initial trigger for underperformance was the scandal surrounding the internet group Livedoor, which included allegations of fraudulent accounting and dealing practices at the company. This had a negative impact on investor sentiment in the early part of the year, while, more recently, concerns about the global economy have been the main factor behind market weakness.
Although all markets wobbled on worries about American inflation and interest rates, the sell-off in Japan was more pronounced. The foreign hedge funds, which in 2005 helped push the market to exceptional returns, have been the main investor category that has cut back risk this year.
Last year returns were exceptional. The 41% return to sterling-based investors helps to explain profit taking earlier this year. It is also worth pointing out that the 2005 rally was somewhat thematic, with a focus on domestic reflation, an area that has been particularly susceptible to profit taking. Companies with the ability to grow earnings both in favourable and more challenging conditions are back in favour.
The past month has brought some respite, with a market bounce, and there are good reasons to believe in continued positive performance. The first is a continued robust domestic economic backdrop. Economic forecasts remain relatively upbeat despite a slightly disappointing second-quarter GDP release caused by lower net exports. The improved environment for employment should support consumer spending.
Business sentiment also reflects a healthier picture. A recovery in capital spending in manufacturing companies, the major driving force of the recovery initially, is spreading to non-manufacturing areas like information services.
The second reason is profits. Companies themselves are being too conservative in their estimates, driven by concerns over higher input costs. It is true that in previous upturns corporate cost control weakened, with an inevitable impact on profitability. In particular, companies have historically allowed factors such as wage costs and capital spending to rise as a proportion of revenues.
Things are different this time, however. With more pressure on management teams to be cautious about the impact on the bottom line, labour costs and spending are under greater control. The ratio of labour costs against sales has declined in the past three years, and continues to do so. Capital expenditure is also under greater control than in previous recoveries. This has enabled companies to achieve rising profits despite higher input costs.
Our analysts estimate 10% growth year on year in post-tax profits, and we expect upward revisions in the quarterly and half-year earnings announcements. Overall, we believe companies that commit to making more efficient use of capital, and to returning excess cash to shareholders, will be best able to enhance returns to investors in the current environment. As a result, we are targeting companies with management teams focused on their company's efficiency, which can therefore achieve strong earnings growth over the next two to three years.
There are some challenges ahead. Management teams still need to focus more on the interests of shareholders. Although the pressure to increase dividends has produced some results, progress has been slow. Dividend growth has been slower than the growth in profits, with the yield on the Japanese market at about 1.2%. However, one encouraging indicator for the outlook is the launch of several domestic dividend yield mutual funds. In terms of contributing to longer-term moves to raise company dividends in Japan, this can only be a helpful development.
There are some tax increases in the pipeline, but these have been known about for some time, and the anticipated rise in the consumption tax looks unlikely before spring 2009. The Bank of Japan ended its zero interest rate policy, increasing rates to 0.25%. If one ignores the previous attempt to end Zirp in 2000, Japan has moved into its first interest-rate raising cycle for about 15 years. The BoJ's move in mid- July was so widely anticipated that it had no major impact on the market. The impact will come from the pace of further tightening, with the risk that the central bank moves too quickly and chokes off recovery. However, our view is that the central bank will move cautiously, as there are no significant inflationary pressures in Japan at present.
Overall, we are not overly concerned about these small potential clouds on the horizon and believe that, if companies announce upward revisions to conservative earnings forecasts, the recovery in Japanese equities that began in recent weeks can continue.
Copyright: Centaur Communications Ltd. and licensors
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