Japanese Market Outlook, July 1998

Market rises as decisions made

TOPIX surged 6.5% last week as the government brought out its Total Plan for Financial Rehabilitation and then topped it off with suggestions from PM Hashimoto that permanent tax cuts should be implemented from next year. Although the bridge-bank scheme may not work out as neatly in practice as it appears on paper, the fact that the government was racing towards a decision instigated a round of short-covering, leading to a gain in the market which encouraged additional money to come in. As a result, foreigners appear to have become buyers last week for the first time in 17 weeks. Although the Nikkei has risen for eight straight days for the first time since Feb 91, TOPIX has declined for two days in a row, pulled down by bank shares. The forex market has not been as keen on the Total Plan as the stock market has, and that may be why Mr Hashimoto reversed course on permanent tax cuts last Friday. A less charitable view about last week's rally is that the substance of Japan's economic policy is now being set in Washington (discreetly, of course), and that investors will benefit as Japan is transformed into a consumer society and speeds the clean-up of its bad-debt mess with Yankee resolve.

Permanent tax cuts

Aside from a cut in the top tax rate from 65% to 50%, the LDP also proposes that the floor for the minimum tax rate be lowered and that taxes be raised on pension payments and on interest income. Although few details have yet been decided, it is possible that the flat tax rate of 20% on interest income will be raised to the marginal tax rate, a move which would hurt savers (but might encourage consumption). The proposals should be good for continued gains in retail stocks. Department stores (4.9% outperformance last week), superstores (+7.2%) and consumer-electronics retailers (+7.2%) are still quite low relative to their 20-year trading ranges. Marui (+1.7%) and Ito-Yokado (+3.3%) are very close to their all-time relative highs.

"Tokuseirei"

The word "tokuseirei" is popping up more frequently these days, in reference to the possibility that some of the debts owed by construction and real-estate companies could be forgiven. The government has been considering policies related to debt forgiveness (see Walter Altherr's Apr 23rd report entitled "Banks' tax write-offs for debt forgiveness"), and support for the idea has come from MOF Minister Matsunaga: "the law provides for the abandonment of loans; it does not mean that special benefits are being given to certain debtors. If the parties involved agree, it can speed up the resolution of the bad-debt problem." The word itself comes from the Muromachi period, when a decree by the shogun wiped out all the debts of certain loyal samurai. Some LDP members support debt forgiveness for real estate and construction on the view that it would improve the flow of money, get properties moving, generate profits and help out local economies. LDP member Uetake says that it is okay to adopt "tokuseirei" at times of social transition and that "in the current crisis, economic recovery is more important than fairness." Of course, if banks do forgive loans to the bubble sectors, the cost will be borne by the taxpayer, since part of those losses can be written off against taxes. This week's Ekonomisto asserts that the LDP has a list of particularly weak real estate and construction firms, and that they may be willing to reveal the names of the very weakest to defuse public outcry at debt relief for the survivors. Construction bosses have not been shy about supporting the idea: "the government has kept interest rates at ridiculously low levels and arranged Y30 trillion to help out the banks; now it is our turn to get some help." And with 6.6 million employee/voters, help just might be on the way within this week.

Tax breaks on mortgage interest?

But what about the poor schmucks who bought a house (in line with policies promoted by the government) anytime in the past 10-15 years and whose outstanding mortgages now exceed what they could get if they were to sell their homes, since land prices have gone down? If the LDP is going to forgive the debts of contractors and developers, shouldn't it also offer more tax benefits on the interest paid on mortgages? The Nihon Keizai Shimbun is advocating that such mortgage benefits be included with income-tax reductions, and in its Sunday editorial, it wonders why the LDP has never proposed better mortgage-interest tax benefits.

Let Yamanouchi pay

As banks and contractors chalk up trillions in tax-loss carry-forwards, tax revenues are likely to remain depressed even after the economy recovers. MOF has just reported that tax revenues in FY97 fell Y1.5 trillion short of expenditures despite the Y5 trillion hike in the consumption tax!! To cover the shortfall, the tax authorities have apparently decided to shake down exporters such as Murata and Yamanouchi on their transfer pricing practices. After all, that is where the money is (and to think they made it all without any government help!).

Technical picture

Last week's rally leaves the market with a technical situation very similar to that of two previous bear-market bottoms, in Aug 92 and Jul 95. The Aug 92 bottom coincided with the first economic package and the start of PKO; the Jul 95 bottom marked the start of the effort to end the ultra-strong yen. The two previous rallies started with sudden bursts of gains, with the one in Jul 95 as mysterious as the one which occurred last week; they also featured several days of consecutive gains which led to extreme short-term overheating vs the 25-day m.a. (the swing in the spread vs the 25-day m.a. was from -8.1% to +14.9% over 8 days in Aug 92 and from -7.8% to +10.3% over 20 days in Jul 95; this time we have gone from -4.6% on Jun 16th to +7.37% on Jul 3rd). The early stage of the previous rallies were accompanied by big gains in low-priced speculative issues, a sign of recovering confidence that is evident again. Whereas the '95 leader was Kanematsu NNK (which rose from Y389 to Y3,470), this year's star is Ishikawa Mfg (up from Y49 to Y726 so far). Three stocks doubled last week. Overall volume has improved; the 54.7 mn shs traded in Nippon Steel last Wednesday was that stock's highest in 6 years. Finally, TOPIX last week managed to get above its 13-wk, 26-wk and 200-day moving averages in a single bound, and the 26-week m.a. had already been in an uptrend for 2-3 weeks. Athough TOPIX was able to get above its 26-wk m.a. for a brief time in Feb 98, the 26-wk m.a. itself was in such a sharp downtrend that the TOPIX could not hold that level; now it has underlying support from this major m.a. Thus: although the fundamentals might be the worst we've had so far in the 1990s, and although it is not rational to expect that the leadership which has so badly managed Japan for the past decade can now set everything aright, the technical conditions are similar to those which led to a 47% gain in Aug 92-Jun 93 and to a 56% gain in Jul 95-Jun 96.

Winners and losers

The strongest subsectors last week were Cements +14.0% vs TOPIX, Sekisui Chemical +12.3%, Shipbuiding +12.3%, Spinning +10.3%, Trading Companies +9.0%, Plant +8.4%, MHI +7.5%, Real Estates +7.3%, Consumer-Electronic Retailers +7.2%, Superstores +7.2%, Electric Steels +6.7%, Big Steels +6.6%, Nichiei +5.8%, DDI +5.7% and Bearings +5.3%; the weakest subsectors were Secom -7.4% vs TOPIX, Blue-Chip Components -7.3%, Game Machines -6.1%, Gas -5.8%, EP -5.5%, Canon -4.9%, Rohm -4.2%, Telecom Construction -4.2%, Kyocera -3.8% and IC Chemicals -3.5%. Tires closed the week at a new relative high; there were no new relative lows.

Materials, machineries advance

Despite the 11.2% YoY decline in industrial production, and despite the fact that JF expects no YoY growth in industrial production for another 18 months, materials and machineries were among the market's biggest winners. Although steel inventories edged down 1.5% MoM, the inventory-to-shipment ratio rose; yet the steel sector rose 13.7% on huge volumes. The charts are extended over their 13-week moving averages, but major overhead supply is comfortably above current levels (roughly +22% to Y330 on Nippon Steel, +40% to Y200 on Kobe, +45% to Y1,100 on Tokyo Steel). An update on the bearings industry by Hoshino-san suggests downward revisions will be coming, yet the group has outperformed by 36.5% YTD and 5.3% last week. Incongruous outperformance was also seen last week in Construction Machinery +3.8%, Big Chemicals +2.3% and Machine Tools +2.1%. Similarly, the cable sector rebounded from 5 months of underperformance with a relative gain of 3.9%, even though shipments in May were down 42% for optical fiber aand 16% for copper cables. Does the market expect industrial recovery sooner than economists do?

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Market Outlook, July 13-17

The election and the market

As we write on this Sunday of the Upper House election, we do not yet know if the LDP managed to win the 61 seats needed to declare victory, but the history of the past elections suggests that the market will go up whether the LDP wins or loses. In the '92 election (when the LDP won big), the Nikkei was up about 5% one month after the election; in '95 (when the LDP was humbled), the market gained about 10% in the subsequent month. Volumes tapered off late last week as the LDP's standing in the polls waned, mainly because of PM Hashimoto's flip-flop statements on tax cuts. Despite the market's distaste for Mr Hashimoto, it probably would prefer the LDP to win back its 61 seats so that the Total Plan for Financial Revitalization bills can get through the upcoming Diet session smoothly and so that the LDP can make good on its international promise to pass permament tax cuts.

Technical picture

The technical situation is still bullish (ie, still above 13-wk and 26-wk moving averages), but not as positive as a week ago. Having declined in 5 of the past 7 sessions, TOPIX has dropped below its 200-day m.a., and volume has been easing off since the peak of 924 mn shs on July 2nd. Once TOPIX had rebounded to 1,270, it started running into increased selling pressure because 1) it was approaching the Feb high of 1,300 and 2) it was above the March close of 1,251.70, which means that domestic institutions could start realizing profits. This they did, since every category of domestic investor sold into the rally. It was surprising to find that individual investors boosted their net selling in the week of the rally to Y162.4 bn, the highest level since Apr 96. Given last week's big volumes and extremely big gains in low-priced stocks, we had assumed that individuals were coming back into the market as they did in the summers of '92 and '95. Alas, it was only dealers; there is no new money coming into equities from individuals yet. The 6.5% rally in TOPIX in the week ended July 3rd was led entirely by foreigners (whose Y323.9 bn of net buying was the highest since Mar 96) and dealers (Y103.9 bn).

Winners and losers

The strongest subsectors last week were Consumer-Electronics Retailers +10.6% vs TOPIX, Blue-Chip Components +6.2%, Discounters +5.9%, Restaurants +5.7%, Trucks +4.8%, Housing Materials +4.7%, TV Broad-casters +4.7%, Software +4.3%, Downstream Chemicals +4.3%, Kyocera +4.3%, Game Machines +4.1%, Rohm +3.8%, Turnaround Components +3.7%, Precisions +3.4%, Nonferrous Metals +3.2%, Fuji Film +3.2% and the OTC Index +3.1%; the weakest subsectors were Cements -11.3% vs TOPIX, Spinning -6.9%, DDI -6.6%, Airlines -6.5%, Trust Banks -6.4%, General Contractors -5.2%, Sekisui Chemical -5.1%, Big Steel -4.95%, SPE -4.6%, Shipbuilders -3.7%, Construction Machinery -3.7%, Gas -3.4%, Warehouses -3.3% and IBJ -3.1%. New ten-year relative highs were achieved by Kao, Restaurants and JR East; new relative lows by Spinning, Trust Banks and Airlines.

Controlled Inflation

The concept of "controlled inflation" got a lof of attention last week as a new panacea for Japan's economic problems. The idea is that the BOJ should target a certain level of acceptable inflation (say 3-4%) by injecting funds into the money markets with the aim of creating negative long-term interest rates and instilling in consumers an expectation that inflation will continue. The concept is advocated by Paul Krugman in his recent essays on Japan's Liquidity Trap and has been supported by Professor Itoh of Tokyo University, Mr Ueda of the BOJ, Mr Yamasaki of the LDP and others. JF's Chris Calderwood doubts that BOJ efforts to achieve a targeted inflation rate would be successful, mainly because much of the extra yen created would join the capital flight (net portfolio outflow in June exceeded Y1 trillion) and lead to a crash in the yen. Other skeptics think that any BOJ effort to create inflation would either overshoot (ie, they wouldn't be able to stop it at 3%) or else lead to stagflation (the recession continues, but with inflation). Whatever comes of this debate, it did lead to weakness in both the yen and JGBs last week.

Weak-yen beneficiaries

The 1.5% rise in dollar/yen last week did not help all exporters equally. Backed by strong Play Station sales and positive domestic sales in June, Sony is steadily approaching its all-time high (Jan 98) of Y12,700. Aiwa just set a new high (Y4,750) on July 2nd and Sony Music (Y6,190) is marching towards its Mar 94 high of Y6,780. Other strong electricals include MEI, MCI, Alps, CMK, Rohm, Murata and Nichicon. However, the big electricals remain sluggish despite a few positive signs coming from the US (SOX index rising, PC stocks surging, Windows 98 off to a strong start) and Intel suppliers Ibiden and Shinko Electric have fallen into downtrends. Keyence fell further and has underperformed by 23% YTD; it has not participated in the recent rally in other machinery groups such as Machine Tools +28% vs TOPIX YTD and Bearings +47% YTD. The Auto sector is being led by Honda (new all-time high of Y5,250 on Friday), Fuji Heavy and Nissan Diesel; Toyota (-3.6% last week) can't seem to break through its declining top pattern.

Retail stocks rally

The Consumer-Electronics Retailers was the strongest subsector last week, backed by reports of a few days of strong air-conditioner sales and indications that the World Cup generated some demand for new TVs and VTRs. The stocks are still bombed out, well below the levels of 18 months ago, and seem to be in the early stages of recovery. Of course, skepticism about the recovery prospects remains deep, especially since consumer sentiment surveys are hitting new lows just as unemployment is hitting new highs. Restaurants are a surprise, as they have moved to a new all-time relative high. Denny's is in the strongest uptrend while Skylark is in the youngest. Last week Shimamura surged on strong June sales, Shimachu poked above its moving averages as if it wants to move back to its old trading range around Y3,500 (+42% from here), Seiyu surged on record volume following bullish comments from ING Barings and Izumi (17.7X PER, 0.75X PBR, mkt cap Y56.8 bn) has one of the best charts in the market. Izumi's chart is reminiscent of Kokusai Securities in late February, when it rose to Y1,150 to break out of its base; last week it closed at Y1,550 (34.8% above its post-breakout price).

JF still bearish

JF's new Quarterly reports on the economy and strategy maintain decisively bearish views, with the economy seen staying mired in recession for another 18 months and with the market vulnerable to a level of 13,500 or below. Both reports emphasize the problem of excess supply (of production capacity, labor, debt, inventory, etc) and hold that real recovery cannot come until those excesses are corrected. Giles Ockenden's strategy note (p5) argues that big companies have to be more aggressive in cutting labor costs in order to bolster OP margins. One company which is ahead of the pack in this regard is Mitsui M&S, whose president was interviewed in this week's Nikkei Business. Since nonferrous metals companies faced deflationary forces long before the rest of Japan did, President Miyamura's response provides a good model for other companies. He 1) cut labor costs by eliminating automatic pay hikes from 1996, found 600 employees to take early retirement, and now bases bonuses on consolidated profits, 2) closed down loss-making divisions/subsidiaries and 3) is shrinking the balance sheet. Directors' pay is linked not ony to profit performance, but also to how much they reduce debt. As a result, debt has declined by 12% over the past 3 years and Mitsui last year earned the same net profit as Mitsubishi Materials with only 35% of Mitsubishi's sales. Capex is focused on competitive areas like copper foils, Ni-Cd batteries and LCD films.

Softbank, Acom into new markets

At a time when most of corporate Japan is reeling from declining sales and high fixed costs, a few companies (such as Aiwa and NIDEC) are expanding aggressively. Last week Softbank used some of the $650 mn it raised from the listing of Ziff Davis to expand its exposure to the internet juggernaut. Although the valuations on Yahoo! are staggering for most investors, Softbank decided to put another $250 mn into the stock at its current market price. Then last Friday it announced a $400 mn investment for a 27.2% stake in E-trade, on the conviction that on-line investment wil be one of the biggest growth areas on the internet. Meanwhile, Acom has signed on to start issuing MasterCards from next year, and may follow with e-money services on MasterCard's Mondex system. This kind of diversification should bring some revaluation to the consumer finance stocks, which have underperformed by 17% YTD. As Walter Altherr has observed, Travelers (Salomon Smith Barney) has its origins in a sarakin company--the old Commercial Credit Corp.