Archives for June 2013

A believer in the Abe lever – Japanese shares

The end of bear markets are periods when investors are delighted that they do not own a certain type of asset.  This usually means that the performance has been very poor for a long period of time, and for reasons that most investors believe will persist.  Typically, on long term valuation criteria the assets are understood to be cheap, but no one can envisage a situation whereby the valuations should rise.

Bull markets begin at the end of bear markets and tend to occur in three waves – the first wave, which we have just witnessed in Japan, occurs amid disbelief and surprise.  The second wave occurs as investors shift from disbelief to belief and it appears quite rational to buy as the fundamental news improves, and the third and final wave is the bubble wave as investors shift from belief to high conviction that prices must continue to rise, because the fundamental story is so compelling.  Between each wave is some sort of correction, which can encompass sharp falls in share prices.

Japanese shares were in a bear market for 23 years from 1989 to 2012 – there are probably few investors around today who can remember the last time Japanese stocks were in a bull market.  The major indices had fallen by 75% over that period, and by last year the equity weightings of domestic Japanese financial institutions were minimal and their portfolios dominated by government bonds with near zero yields.  In addition, many international investors were extremely comfortable with low or zero weightings to Japanese equities in their portfolios. Economic growth has been zero in nominal terms (that is including inflation) for over 20 years, and the legendary Japanese trade surplus of former decades has now become a trade deficit, following the Fukushima accident, the shutting down of all of its nuclear power plants and the consequent need to import a far greater amount of its energy requirements.  It boasted the largest government debt to GDP ratio in the developed world.  Investors who did own Japanese shares, made sure that they did not own very many, as it was so difficult to justify such positions to clients or managers.

By last autumn, over 70% of companies listed in Tokyo traded below book value, and the dividend yield of 2.5% was 3 times the yield available on a 10 year Japanese government bond, even though the dividends paid by companies in the stock market had doubled over the previous decade.  Japanese shares were very cheap but investors would not buy them, because very few believed that the Japanese economy would get back onto a path of growth.  Japan fulfilled all the conditions for an end to its long bear market.

Then, last December, Mr Abe, one of the many former prime ministers of the last decade who had proved ineffective and short-lived, and who regained the leadership of the LDP, fought a general election campaign asking for a mandate for dramatic change to set Japan’s economy on a course for growth.  His plan consisted of three pillars: (i) a short term fiscal stimulus of government investment spending, to boost demand in the short term; (ii) a shift in monetary policy aimed at boosting inflation expectations that would boost demand in the economy in the medium term; and (iii) a package of structural reforms to increase the economy’s long term potential growth rate.  This policy mix was eerily similar to that adopted by Japan in the mid-1930s, which successfully brought their economy out of the problems caused by the Great Depression.

His political timing was excellent in that: (i) the Governorship of the Bank of Japan was an appointment that needed to be made in the first quarter of 2013, and in many people’s eyes it had been the Bank of Japan’s conservative approach to monetary policy management that had been holding back the economy; and (ii) the Upper House elections were due to be held in July 2013, giving him the rather rare opportunity to gain a majority in both Houses of the Japanese Parliament at the same time, and thus be in a position not to have to compromise with opposition politicians.

In a matter of weeks, the consensus view of the prospects for Japanese markets had reversed. Rather than a stagnant economy with no change to policy, there was to be a dramatic shift to a pro-growth and most crucially to a pro-inflation stance.  At the heart of the policy shift was a change in the Bank of Japan’s inflation target from 1% to 2% and a belief and determination from inside the Bank of Japan that this could be attained.  This required a Governor who believed that creating higher inflation was possible, which the outgoing Governor did not; the change from Mr. Shirakawa to Mr. Kuroda brought this in one fell swoop.  To achieve this, Kuroda immediately announced a programme to print 6 trillion yen a month for two years, and so double Japan’s monetary base.  The aim of this programme was and is to raise inflation expectations, and encourage consumers and businesses to spend now, to hold down interest rates, and so reduce real yields in the economy, and most importantly to weaken the yen.

The weaker yen is an enormous boon for Japanese profits, whose companies sell so much around the world.  The profits of the large Japanese companies are very sensitive to the value of the yen, rising strongly as the yen declines.

Over the early months of 2013 the market suddenly found itself with increasing earnings forecasts, low valuations, enormous supplies of liquidity, and with most investors holding very little exposure to Japanese equities, but who believed that they needed far greater exposure.  The market rose rapidly, gaining almost 80% in the seven months from October 2012, to 1276 on the Topix index; this was partially offset for many international investors, who neglected to hedge their currency risk, by a fall of 25% in the value of the yen.  In the three weeks following the market peak on 22 May 2013, it has fallen back by almost 20%, though this still leaves it at the levels it was trading at in early April and 50% higher than the lows from last year.

There are those who believe that Japan has entered a bubble, but bubbles occur at the end of long bull markets, not after just seven months when many investors have had little opportunity to build positions.  The critical insight is that the market psychology on Japan has changed, from being uninvested and comfortable with that position, to being lightly invested but very uncomfortable with that position.  Apart from very short term orientated investors, who have profits to bank, and so will do so, most investors will now concern themselves with being underinvested in Japan, and so any positive news on Japanese growth, Japanese corporate earnings, easy monetary policy and a weaker currency will be seen as good news, and lead them to increase their weightings to Japan.

This summer is likely to see a continuation of the recent correction, as shorter-term investors take their profits and search the world for their next opportunity, and are replaced by longer term investors who need to build up their positions in Japan.   Thereafter, either the Japanese economy will begin to grow faster and inflation pick up a little, which will justify higher share prices, or if growth and inflation are not picking up, then the Bank of Japan will be forced into even greater money creation, and an even weaker yen which would also boost share prices.   In either event, a second wave of the bull market should be expected to begin later this year, though it will be critical to invest in Japanese equities with the currency hedged, since one of the major factors in stronger share prices will be the weaker yen, caused by the aggressive printing of money by the Bank of Japan.

UK economy – green shoots

Over the last ten quarters to March 2013, the UK economy has produced essentially zero growth due to a combination of (i) the UK government’s austerity plans encompassing both spending cuts and tax increases, (ii) severe economic weakness in the Eurozone, the UK’s largest trading partner, (iii) weakness in North Sea oil production due to essential maintenance work,  (iv) a large banking sector engulfed in a series of scandals, which have damaged their profitability, and (v) declining consumer real incomes

During this period the UK economy has consistently disappointed the expectations of the Bank of England, the Office of Budget Responsibility and the IMF, as well as many private sector forecasters.  In recent weeks however, this trend of disappointing expectations has come to an end, and the Bank of England, in Mervyn King’s last presentation of the state of the UK economy, upgraded its growth forecast for the UK in 2013 from 1.0% to 1.2%.

Beneath the headline figure of zero growth, there have however been two important improvements in the UK economy, which give encouragement to longer term recovery prospects as follows:

  1.  The structural budget deficit (that is after allowing for the extra government spending and lower tax revenues that arise from a weaker economy) has been reduced by over 4% of GDP in just 3 years (or 1.3% per annum) .Given that state spending is about 40% of the economy, it has required the other 60% (the private sector) to grow at about 1% per annum over this period, merely to offset the public sector weakness and achieve zero growth for the economy as a whole.  This 1% growth from the private sector is quite an achievement in the face of so many headwinds for consumer and government spending.  Though the structural budget deficit remains too high, there has been good progress in reducing it.
  2. The flexibility of the UK labour market has surprised many.   Despite the economic weakness, unemployment has stabilised at around 2.5m rather than the 3m that many commentators expected to see when the crisis first hit.  The major reason for this has been workers preparedness to take pay cuts or not demand pay rises to preserve their jobs – UK wages are only growing at about 1% currently, and have been well below the rate of inflation for four years. By contrast, French unemployment (France has essentially the same population and size of economy as the UK) has gone through 3m and is still rising.

The weather has played a surprisingly key role in the UK economy over the last twelve months – last summer was extremely wet (excepting the period of the Olympics) and both of the last two winters have been very cold and wet.  This has had a very serious effect on the construction industry, which had already been extremely weak over the life of this government, first from a cutback in government investment programmes, and secondly from weakness in UK housebuilding.  Just a return to normal weather over the summer and next winter should see a sharp improvement in construction spending, and with it the demand for construction workers, and the prospects for an improvement in overall economic growth.

There are other reasons though for being more confident. The electoral clock is now audibly ticking, and though the government will not reverse course on their austerity programme, they will be more sympathetic to ideas, which boost economic growth in the shorter term, particularly if they can be labelled as “investment”.  Importantly too, the new Governor of the Bank of England has been selected because he is an activist who believes that monetary policy can make a difference to the real economy. He has already been granted a more flexible mandate than just the control of inflation. Growth is now almost as important, and more emphasis on getting funds into the hands of industrial borrowers can be expected.

In the run-up to the 2015 election, there will be a more marked policy bias to boosting growth, and with the underlying improvements that can already be seen in the UK economy, it is likely that growth will exceed the (very low) expectations that currently exist. Note though that this is a forecast of modest improvement rather than of a boom.

The investment implications of beating the low expectations that exist for the UK economy are that, after two decades of performing much worse than either large or mid-sized companies, smaller companies in the UK, who are most exposed to the strength of the UK domestic economy, may be about to benefit most from the improving economic trends.  Where client portfolios do not have specific smaller companies exposure, we will be seeking to include it in any recommendations, as appropriate.