The return of Japan

Many analysts think that Japan's recent economic recovery is another false dawn - just as it was in 1997 and 2001. Jonathan Allum disagrees. Corporate Japan is back on track, he says, and a bull market in equities could be on the way.

A dismal historyIt now seems barely credible, but there was a time when Japan had the largest, most dynamic stockmarket in the world. In 1989, the Nikkei 225 all but reached 40,000 and everyone expected that within a few years it soar above 100,000. But it never happened. The market stumbled, the economy crumpled, and the go-go 1980s became the stop-stop 1990s, a grim attritional period, a bit like World War I, only more than twice as long (and minus the poetry). There have been glimmers of hope since, but all the dawns turned out to be false. In 2003, the Nikkei finally fell below 8,000.

But then the Nikkei bounced hard. By the end of 2003, it was back in five figures. The good times, we dared to hope, were about to roll again. Or were they? In 2004, the Japanese stockmarket resembled nothing more than an English cricket innings. A promising beginning was followed by the usual middle-order collapse before some lusty hitting by the tail enders brought some respectability to the final total. Over the year as a whole, the TOPIX index rose 10.15% - perfectly respectable, but a distinct anticlimax after the 23.77% it achieved in 2003 and the hopes raised by the 13.66% gain chalked up in the first four months.

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The economists say recession's back

Japan is generally seen as a cyclical market, waxing and waning according to the fluctuations of the economy. Like any market, it attempts to anticipate what will happen next, rather than just follow events. As usual, Mr. Market spotted the slowdown before the practitioners of the dismal science - the TOPIX peaked in mid-April 2004, but economists were still ratcheting up their numbers until August/

September, when they, too, spotted the change. That Japanese economic growth all but evaporated in the second and third quarters of 2004 is a matter of historical record. The official government line is that this is a pause, after which growth will resume. The general response is one of polite scepticism - they would say that, wouldn't they? - and the fear among the analysts, who only a few months ago were being much too optimistic about Japan's prospects, is that Japan is once again slipping back into its bad old ways and thus into recession.

The market says it isn't

But Mr. Market would appear once again to disagree - the TOPIX bottomed most recently on 26 October and has since rebounded by some 6.3 %, suggesting there is every chance that economic growth will resume.

The conventional view is that growth in Japan - if there is to be any - inevitably comes from exports. Yet the classic export sectors, the car and the electrical sectors, are both among the worst-performing. In fact, the sectors that have bounced hardest from the bottom have nothing to do with exports. Instead, they are geared primarily to domestic recovery (although not to personal consumption - which remains anaemic, if a little more robust than the retail figures suggest). The keys to recovery seem to lie with property (real estate is the best-performing sector, with the banking sector - to which it is closely linked - coming in at number three) and private-sector capital expenditure (machinery is at number four and construction, with links to both capital expenditure and property, comes in at number eight).

Property really is looking up

The bottom to the bear market in Japanese property has often been spotted shimmering in the distance, but, on closer inspection, has always turned out to be a mirage. Having waited so long for the rebound, one has been tempted to conclude that Godot was more likely to arrive. The quality of data in this area is not good, but evidence is beginning to mount that, at least in central Tokyo, office vacancy rates have begun to fall and rents have started to edge marginally higher.

What is quietly impressive about this ostensibly modest recovery is that it is occurring at a time when many had expected the market to take yet another lurch downwards. For years, analysts and investors had been fretting about what was called the 2003 problem' - the large amount of newly developed property that would hit the Tokyo market in 2003, especially the Mori development at Roppongi Hills. But 2003 has been and gone, and prices have not collapsed further as predicted - in fact Mori itself, which had been expected to be saddled with an excess of old property as it moved its tenants into its spanking new buildings, has just announced that it is looking to increase rents for new tenants in these older properties by around 10%, the first rise in many years.

Companies have profits and cash

Capital expenditure had played a full part in the recent economic recovery until, like the recovery itself, it stumbled in the middle of last year. For many observers this was game over - the recovery had lasted about as long as an average economic upturn and thus had nothing to do but crawl into a corner and quietly expire. But it hasn't turned out like that. In fact, recent data related to corporate investment (the Tankan, the Ministry of Finance capital investment survey, machinery orders, machine tool orders, etc) has been pleasingly robust.

The economy is erratic, but reformed

This brings me to the heart of the bull case for Japan. Since it emerged from recession in 1998, the Japanese economy has followed an erratic and - it must be confessed - disappointing course, slipping back into recession in 2001-2002 and, after the latest revisions, again in 2002-2003. But Japan Inc's performance over this period has been much more impressive, with 1998 appearing to have been the watershed year. This was the time of the Asian currency crisis, the Russian debt crisis, the implosion of both US-based hedge fund LTCM and Japanese bank LTCB. The whole Japanese banking system seemed to be teetering on the edge of the abyss. But it never quite fell - the government launched its long-delayed bank-restructuring programme and corporate Japan finally began its long haul back to respectability.

Over the last six years or so, corporate Japan, despite two further recessions and persistent deflation, has struggled to get its act together. Companies have returned to their core competences, stripping themselves of the more outlandish diversifications that were popular during the go-go 1980s. They have reduced costs and staff, largely through natural wastage. They have rebuilt balance sheets. They have cut capacity and capital expenditure. And as a result of all this activity, they have, using such standard measures as return on equity or operating profit margin, become surprisingly efficient. They have also become surprisingly profitable.

For the half year to the end of September 2004, for example, the sales of listed companies were up 5.4% year on year (YOY) - not startling, but more than respectable and very much better than the norm of the previous few years. On the other hand, operating profits jumped a genuinely impressive 26.4%. For the manufacturing sector, the performance was even more striking - a gain of 7.2% YOY in sales was leveraged into a 39.6% jump in operating profit.

Cash all over the place

Japanese companies are currently throwing off prodigious streams of cash flow. The 64trn question is what they will now do with it, if, as many companies seem to believe, they have paid down their debt to tolerable levels so they no longer need it for that. Investors - and especially foreign investors - are dreaming of getting their hands on it via higher dividends and share buybacks. Their dreams may, partially, come true. Workers, whose incomes have been sliding for years and who have run down their savings to supplement their income, will ask for a rise. And they too will be partially satisfied - overtime payments have been rising, albeit modestly, for some time, and even regular wages appear at least to have stabilised.

Japanese companies will, however, be aware that they are running at generally high levels of capacity utilisation, using equipment that is dangerously long in the tooth (this may be why there seems to have been a lot of industrial accidents reported over the last few years). Chart 4 on page 19 shows the average age of Japanese capital equipment. Japanese firms have put off replacement for years, but now they don't have to any more: not only may they need to replace their machinery, but they can afford to do so. A lot of the cash currently sloshing around Japan is going to end up in the machinery sector.

It was noticeable that in the Industrial Production report for December - which showed that output in total declined 1.2% from November - production of machinery (ie, things that make things) was up 1.3%, and that of industrial robots (ie, clever things that make things) rose no less than 6.3%.

Four big ifs' make a chair

If this capital expenditure cycle has, as I suggest, further to run, and if there is finally light at the end of the property tunnel, as it seems there is, we have two legs to a sustainable recovery. And if the current tightness in the labour market (the unemployment rate in December was at a six-year high) finally feeds through, as economics suggests that it should, into higher wages, which in turn helps fuel consumption, we could have a tripod. Add a rebound in exports as growth persists in the major export markets of Asia and North America and we have a full chair. Finally, there is also the chance of a possible recovery, after years of decline, in public works expenditure, as the damage caused by last year's typhoons and the Niigata earthquake is made good. That would be a nice little bonus for the economy.

The renaissance of JapaAll in all, it is not difficult to talk oneself into a state of heightened enthusiasm for the Japanese stockmarket. It may be that my judgement has been distorted by the long, lean years I have worked through in the market and, of course, one must not forget that Japan is still a low growth, mature economy with dodgy demographics, a humungous fiscal deficit and an uncanny habit of making the wrong economic choices.

But on the plus side, one must also remember that, as an equity investor, one is not directly exposed to the negative factors listed above. The direct exposure is to corporate Japan. And at the very least, one can comfort oneself with the knowledge that corporate Japan is in better shape than when it entered the downturns of 1997-1998, 2001-2002, 2002-2003, etc. At the very best, we could be on the threshold of a renaissance of Japan Inc.

There was a time when Japanese companies were seen as the Masters of the Universe (pick up Michael Crichton's Rising Sun in a charity shop to be reminded why). In the subsequent decade they may have become a laughing stock, but Japan's corporate sector remains a force to be reckoned with. The car in front is still a Toyota

The views expressed in this article are the personal views of Jonathan Allum, who is a Japan strategist at KBC Financial Products UK Limited and previously worked at ING and Morgan Stanley. KBC Financial Products UK Limited does not dealwith private investors