Fingers crossed for Japan

The “recent volatility in Japanese equities has made investing in Japan look risky”, says Jupiter fund manager Simon Somerville in a report from his most recent trip to Tokyo. I think we can all agree on that. He then goes on to explain that underneath all the money printing tomfoolery and the huge swings caused by the market’s various panics “Japan still offers a real recovery story”.

Regular readers will know that I am convinced of the long term strength of Japan. They might also know, but I will mention again for disclosure’s sake, that I sit on the BG Shin Nippon investment trust board with Simon, and his comments on his trip do nothing to change my view.

He points out that the domestic economy is “noticeably recovering”: consumer spending and house starts both look strong, and many companies say that they are “planning to increase capital spending sharply this year”. Overall sentiment looks good too – no doubt helped by a 7% rise in summer bonus payments (the biggest rise since 1990) and some – albeit “nascent and sporadic” – signs of wage growth as well as a little mild inflation.

Still, while we like to hear good things about the economy, what of the market? Somerville thinks it is now very undervalued again. He also points out that the recent strength of the yen against the dollar can only be temporary. Japan is just about to go for broke with its new style quantitative easing (QE) programme while the Fed is desperately trying to reduce the rate at which it chucks new money into the American economy.

So – if there is any logic left in financial life at all – the yen should weaken against the dollar again this year. That’s good for corporate profits – which are forecast by Nomura to rise by 66% this year (for companies listed in the first section of the Tokyo Stock Exchange) if the exchange rate averages around ¥100 to the dollar.

There are still risks here (I guess that much is obvious). The first is Abe himself – Japanese PMs have a history of not lasting their terms without resigning or getting mired in reform stunting difficulties. This wouldn’t help much.

But the real thing to worry about is wages. If there is to be cost push inflation from the falling yen, says Simon, the market will need to see wages rising to offset price rises and to keep consumer confidence rolling.

The other part of this problem of course is that, as Andrew Smithers points out, if wages do rise – and so the share of output going to labour rises, so the share of output that ends up as profit falls.

That means there is one core reform that is essential to make the Japanese recovery sustainable: corporation tax. The depreciation allowances must be changed – the current structure encourages over investment and waste (more on this here) – and the rate itself must be cut (at near 40% it is very high by global standards).

Smithers doesn’t’ hold out much hope for the latter, but Somerville does. No commitment has been put in place yet, but it may happen after the July Upper House election “as a tax cut has previously been strongly hinted at by the Abe administration”. Fingers crossed.