Today's comment is by Eric Roseman, our Investment Director and editor of Global Mutual Fund Investor.
Dear A-Letter Reader,
I'm writing this commentary from my hotel room in Tokyo. This week's trip marks the third time I've been in Tokyo since last June. Unfortunately, I'm not just here doing research. I'm here for a funeral. Losing a friend is never easy.
But when I travel the world, I always have something to say about the local economy and markets. And when it comes to Japan, there's so much to say - I hardly know where to start.
Japan is an absolute economic powerhouse right now. It's is the second largest economy in the world. And Japan has the third largest stock market after London.
And if you're shopping around for the some of the world's cheapest stocks, Japan is still the most attractive stock market available today. Equities in Japan trade at roughly 1.5 times price-to-book value ratio, or nearly a 35% discount to the MSCI World Index and a 50% discount to U.S. stocks.
In the U.S. and Europe, companies are already aggressively buying back their own stock. But this trend is only just beginning in Japan. That's another bullish sign. And Japanese companies are beginning to boost dividend payouts as well - another big plus for the Nikkei.
Also, Japan's largest companies increased capital spending by 16.8% in the fourth quarter versus 12 months earlier. Corporate profits expanded for the 18th straight quarter, extending the longest streak of growth in 36 years.
So what's holding back Japan, Inc.? In short: Japanese consumers.
Consumer spending in Japan represents 55% of the economy. That's quite a chunk and it continues to slow the country's economic potential. Though corporations are spending money, earning great profits and buying back stock, consumers simply don't spend enough to boost domestic consumption. However, I see this situation possibly changing.
Expect a Double-Digit Rise in the Land of the Rising Sun
So how should you position yourself to profit? Let's start with Japanese small-caps. I'm especially bullish on the Second Section Index of Japanese smaller companies. These companies have been mauled since mid-2006. Compared to the large-cap Nikkei, a rising yen will not affect earnings for smaller stocks.
I'm expecting the Japanese yen and the Second Section Index to rally in 2007 and 2008, providing foreign currency investors with a double-play on capital gains. In 2006, the Second Section Index plunged over 20% in dollars. Historically, previous declines of similar magnitude have resulted in big double-digit gains for small-stock investors in Tokyo. For example, in 2003, following a big market decline, the Tokyo Second Section almost doubled in value.
The yen is also dirt cheap right now. The yen is still trading at a 22-year low versus other major currencies, especially against the euro and its main predecessor before the single currency, the German mark.
I can't help but shudder when I think about how badly the yen-carry trade will end as the Japanese currency finally begins to meaningfully appreciate. The yen has indeed generated a good portion of the world's speculative capital over the last three years. Any serious yen rally will ignite a massive sell-off, making the mini-panics experienced on February 27 and March 13 look like a picnic. Most of this borrowed yen is invested in risky markets, including emerging market stocks, high-yield bonds, small stocks and even some commodities.
I'm Looking for a Yen Breakout!
The Japanese yen versus the euro has one of the most mismatched cross rates on the planet this year. There's no compelling reason for the euro to fetch 159 yen.
It might not happen tomorrow, but at some point, the Bank of Japan (BoJ) will raise interest rates more than market expectations, critically wounding the euro-yen cross.
I can also comment on the Euro-zone economy. Though the region is showing signs of solid expansion, it's not exactly booming, either. Deficits run high, peripheral EU members' economies are severely overheating and labor remains a structural headwind no government can indefinitely control, yet alone restructure.
Even real estate in Japan, once the Mother of all "Bubbles" in the late 1980s, is finally recovering. For the first time in 17 years, Japanese real estate values appreciated in 2006, though mostly in premium areas. I wouldn't necessarily peg the real estate market a bull, but it looks like we've finally completed the secular bear market in Japanese property. I like Japanese commercial real estate as an investment for the next few years, again partially because it's yen-based.
The Only Japanese Asset Class to Avoid
The only asset class that's a bad investment is Japanese government bonds. As the economy continues to recover, The Bank of Japan will continue to raise short-term interest rates to normalize monetary policy, which has remained extraordinarily accommodative since the late 1990s to resuscitate economic growth. Interest rates currently stand at 0.50%.
Inflation, which has turned slightly negative once again, will eventually grow positive as growth accelerates in 2007. But even if inflation remains slightly negative or stays benign, ten-year Japanese government bonds don't exactly make my mouth water at 1.69%.
The yen, smaller company stocks, large-caps and real estate all provide good values in 2007. Japan's economy is making progress as it finally leaves the "lost 1990s" behind this decade. And unlike the Dow and many other international bourses, the Nikkei remains more than 50% off its all-time high in 1990. Bottom line: there's much more room to run in The Land of the Rising Sun.
ERIC ROSEMAN, Investment Director
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