A slow dawn but not a false one

For fund managers who specialised in Japan, 2005 was a fantastic year. After more than a decade of dealing with a market in the doldrums they suddenly found themselves in the middle of a boom: stocks were rising fast, gurus around the world were tipping Japan as their favourite market and Japanese-themed hedge funds were springing up everywhere. Money poured in and the managers — who had looked resentfully at the fortunes being made in US and UK markets for many years — started to live the dream: they opened offices in St James and rushed to buy the cars, boats and houses that the City thinks go with making real money. By the end of the year the benchmark index was up around  40 per cent and they were all rolling in cash.

Anyone with any history in Japan could have predicted what happened next. In 2006, as other markets clocked up another great year, the Japanese market rose a pathetic 4 per cent — and that only because a few big exporters (Toyota, Honda, Canon, Nintendo) did brilliantly; take them out of the mix and the average stock actually fell by about 20 per cent. As for the hedge funds that looked like can’t-lose bets in 2005, they all fell between 5 and 20 per cent. I can’t find a single one that made its investors a real profit all year. The result? Money pouring out again, and all over Mayfair failing funds quietly shutting their doors.

So what went wrong? In 2005 all the elements for success seemed in place. The economy was out of recession; exports had been strong; capital expenditure was rising rapidly as Japanese companies began to expand capacity for the first time in years. Consumption seemed set to expand as wages and employment rose and confidence improved. At the same time, corporate balance sheets had been restructured and Japan’s big companies had come over all shareholder-friendly, with dividends growing and a rise in M&A activity widely forecast. The banks had started lending again and best of all, after falling for 15 years, property prices were rising. All this is still true. The problem is that it is true in exactly the same way as it was at the start of 2006: consumption still looks set to pick up but it hasn’t really done so yet; bank lending is still only rising very gradually; and while property prices are rising in Tokyo, Nagoya and Osaka, they haven’t yet started to move outside the major cities.

It takes a long time for a country to shake off a deflationary mindset and Japan just hasn’t quite got there. When I talk to friends in Tokyo they tell me they’re making more money than they were and their flats are finally going up in value — but still, whenever they can, they save instead of spending. Why? Because last time they got complacent, in the late 1980s, they were rewarded by 15 years of recession. They just don’t trust this recovery yet, particularly with the risk of a rise in consumption tax on the horizon. So they are not going to spend into it and they certainly aren’t going to borrow to spend into it. This continuing downbeat mood caught investors off-guard: they thought consumption would kickstart higher growth in the domestic economy in 2006. But it never did.

Still, getting out of Japan now might turn out to be as big a mistake as staying in it was last year. Global investors are very impatient these days — they like their trades to pay off fast — so for them Japan is a failed investment and the stellar performance of 2005 was a false dawn. But in fact it was more of a slow dawn. Nothing has actually gone wrong. The structural reforms that needed to be made have been made and won’t be unmade. There have been 60 straight months of growth, the best run since the second world war; companies are making their highest profits for 20 years; consumers, especially those near retirement, have cash in the bank; and prices have stopped falling. Japanese stocks — particularly among the mid-caps — in retail, construction, machinery, warehouses and elsewhere are very cheap. You can’t that say about many asset classes these days.

Plus there is another good reason to be invested in Japan: the yen, which is trading at an eight-year low relative to the pound and at lows to the dollar not seen since 2002. That can’t last. First, interest rates in Japan have been sub-normal for too long: as the economy normalises, rates should do so too. That will reduce the interest rate differential between Japan and other countries, making the yen relatively more attractive to investors. It should also bring an end to the ‘Japan carry trade’, in which traders borrow in yen at low rates and shift the cash into higher yielding currencies.

The large amount of money borrowed in yen and then changed into dollars and pounds has been one of the factors pushing down the yen over the last few years, but like most speculative trades this could reverse very suddenly. If you have borrowed at 2 per cent and invested at 6 per cent you’re on to a good thing, but if 2 per cent becomes 3 per cent and 6 per cent becomes 5 per cent, your margin just halved. If at the same time the yen starts to strengthen, you will want to get out fast: carry traders will have to buy back their yen, and if they all do so at once (as is the way with markets) we could see a very dramatic move upwards in the yen.

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, Asia’s biggest and best currency, is the obvious vehicle. The point is that if you buy into the Japanese stock market now, your money has a degree of protection built in: even if your stocks don’t rise you may well make money simply by holding investments in yen. I can’t tell you exactly when the carry trade will unwind or exactly when Japan’s consumers will start shopping in earnest again. But I’m sure both will happen — and over the next two to five years Japan will turn out to be one of the best investments UK-based investors can make.

Merryn Somerset Webb edits MoneyWeek.