Why you should invest in Japan now

In 2006, the Japanese stockmarket disappointed with a mere 4% rise. But don't be put off, say Merryn Somerset Webb and Henry Scott Stokes - this could be one of the best investments you ever make.

After months of speculation and manic politicking, most of the bankers, brokers and dealers working in the City have now finally found out just how big their bonus really is.

But as they dither in the estate agents and car showrooms (a flat in Notting Hill? a Sunseeker Predator 68? an Aston Martin DB8?), those working in the booming markets of the West might spare a thought for their counterparts on the Japanese stockmarket.

There'll be no new houses for them this year. If they're lucky, they might be able to stretch their cheque to a long weekend in Biarritz, but that's about it.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

In 2006, as the world's other markets clocked up another great year, the Japanese market rose a pathetic 4%. And it only managed that because the big exporters, the likes of Toyota and Canon, did brilliantly as the yen fell and American consumers kept spending: take them out of the mix and you find that the average stock actually fell around 20%, with many of the small caps doing even worse.

The really bad news for those invested in Japan is that most of the fund and hedge-fund managers in the market hadn't bought into the winners: instead, they were betting on domestic recovery and had weighted their holdings heavily away from exporters towards smaller stocks they thought would do well out of a rise in consumer spending in Japan. The result? Most of them did badly.

The hedge funds, far from proving their ability to make absolute returns in any market conditions, did particularly badly: they all fell between 5% and 20% over the year.

All this was disappointing, given the fabulous year Japan had in 2005.

Then, after more than a decade of doldrums, the markets suddenly took off: analysts around the world, convinced that deflation had been banished and that the domestic economy was on the cusp of a boom, all started tipping Japan as their favourite market; money poured in; and by the end of 2005 the benchmark index, the Nikkei, was up around 40%.

So what went wrong? In 2005 everything seemed perfect. The economy looked to have moved out of recession; exports were strong; capital expenditure was rising rapidly as Japanese firms began to expand capacity for the first time in years; and consumption was expected to soar as wages and employment rose and confidence improved.

At the same time, corporate balance sheets had been restructured, and Japan's corporate giants had come over all shareholder-friendly, with dividends growing and a rise in mergers and private-equity activity being widely forecast; the banks had also started lending again; and, best of all, property prices, after falling for 15 years, were finally rising.

The problem is that all this is still true, but in much the same way as it was at the start of 2006. Consumption looks like it should pick up, but hasn't really done so yet. Bank lending, positive on an annual basis for the first time in ten years, is still only rising gradually. And while property prices are rising in Tokyo, Nagoya and Osaka (Tokyo residential prices were up 18% last year), outside these cities they haven't yet shifted much.

There are also a few new worries about, the big one being a possible rise in consumption tax. The Japanese were very fond of Junichiro Koizumi ("Junchan"), the last prime minister, and view his successor Shinzo Abe as rather colourless. Since Koizumi left, the Cabinet's approval rating as judged by a regular Nikkei poll has fallen from 71% to a mere 49%.

But while Koizumi had an excellent record in some areas he completely failed to come to grips with Japan's biggest financial issue its exploding public debt. Visitors to the Ministry of Finance are shown nasty-looking charts of the surge in public indebtedness over the last few years, and then have it pointed out to them that in Japan consumption tax is just 5%, compared to the 15%-20% VAT charged in most European nations. "We have to take action", an official told us.

The problem with this is not necessarily that the MoF will be able to force through a tax rise (most think that unlikely to happen for two or three years), but that much of the population worry that it might. This makes it hard for people really to trust the idea of domestic recovery and get their wallets open.

This is the main reason why, last year, the thing that investors thought would happen, and in anticipation of which they invested, never happened: 2006 was not the year that consumers started spending again, and not the year the domestic recovery kicked off. Instead, household spending declined slightly over the year.

Here's the big question: will it happen in 2007? It might. Nothing has actually gone wrong. The big reforms that were needed have been made, and won't be unmade. Japan has seen 60 straight months of economic growth, the best run since World War II; firms are making their highest profits for 20 years and have had five years of continuous profit growth; consumers have cash in the bank; and while inflation is only just positive, prices aren't actually falling anymore.

Housing starts are at their highest level in ten years, says Chris Rigg of Vantage Capital, and the price of land is beginning to go up even "outside the central urban locations". The labour market "is tightening... wages are beginning to pick up" and when that happens, rises in consumption usually follow.

Note that several firms have recently announced wage hikes for the first time in many years. Sumitomo Bank even announced an 18% hike in new graduate salaries as of April.

At the same time, many Japanese stocks especially among the mid caps, in construction, retail, and the like are very cheap, which you can't say about many asset classes these days. Better still, says Pelham Smithers, head of Asian research at Pali International, they are starting to return money to shareholders: for the first time, investors in Japan are getting real dividends.

Rigg considers that the Japanese market to be at a critical juncture. The TOPIX index has "perked up to 1,750" a level it has reached four times in recent months but not managed to break out from. If it does this time, "we could see one of the biggest financial breakthroughs of all these years... to compare with the Dow in the early 1980s."

Reasons to invest in Japan: the end of the yen carry trade

Whether you are convinced by the stockmarket bulls or not, there is another good reason to be invested in Japan: the yen. Right now it is trading at an eight- year low relative to the pound and a four-year low to the dollar. That can't last. Interest rates in Japan have been subnormal for far too long: as the economy slowly normalises, they should do too. That will reduce the interest-rate differential between Japan and other countries, making the yen relatively more attractive to investors.

It should also call an end to the Japan carry trade (whereby people borrow in yen or in Swiss francs at low rates and then shift the cash into higher-yielding currencies such as the Australian dollar or even the UK pound).

The large amount of money borrowed in yen and changed into dollars and pounds thought to be as much as $200bn has been a key factor in pushing down the yen in recent years. This is a trade that has worked particularly brilliantly over the last few months, as interest-rate expectations have remained low (the Bank of Japan declined to raise rates in January, although many thought it was time to) and the yen has continued to weaken.

But, like most speculative trades, it could reverse suddenly. Central bankers are nervous and Jean-Claude Juncker, the chairman of the Eurozone's 13 finance ministers, said this week that he was, "increasingly a little bit worried about the yen", reports the FT. That's strong language for a finance minister.

If you have borrowed at 2% and invested at 6%, as many involved in the trade have, you are clearly on to a good thing. (Note that the UK two-year Government bonds now yield over 4.5% more than Japanese bonds with similar maturity). But if 2% becomes 3%, and 6% becomes 5%, your margins no longer look so safe.

And if at the same time the interest-rate differential starts to close and the yen strengthens, you will want to get out fast. Carry traders will have to buy back their yen, and if they all do it at once as is the way with markets we could see the yen move upwards very dramatically.

The last time this happened, Gillian Tett and Peter Garnham write in the FT, was during the 1998 Russian crisis. "The yen suddenly rose from 147 to 112 in a matter of days, helping to trigger the near collapse of Long Term Capital Management, the US hedge fund."

The final factor in the yen's favour is the Bank of China, which has said it intends to diversify its vast foreign-exchange holdings out of dollars and euros: the yen is the obvious way to do this.

So if you buy into Japanese stocks now, you have something of a hedge built in: even if your stocks don't rise immediately, you may well make money simply because you are holding investments in yen. The yen carry trade may not reverse right away, and Japanese consumers may not start shopping immediately, but both will happen at some point. And possibly sooner than many think.

There is "more than a whiff of excess speculation in the current spell of yen weakness", says Jonathan Allum of KBC, "which makes its reverse in the not-to-distant future highly probable... It seems that on a two to five-year view, Japan could turn out to be one of the best investments UK-based investors can make".