Japan - ett år efter jordskalven

The Great East Japan Earthquake
On 11th March 2011, a powerful 9.0 earthquake hit the north-east coast of Japan, triggering a tsunami that left behind miles of devastation to infrastructure and local communities. Resulting waves reached heights of 40 meters and pushed a wall of seawater as far as 10km inland. At the coastal Fukushima Daiichi nuclear power plant, giant waves crippled the reactor cooling systems, triggering a meltdown in three reactor cores.

Almost one year has now passed since these tragic events and the perseverance of the Japanese people in overcoming the disaster has been exceptional. Affected regions are embarking upon a multi-year rebuilding process and major reconstruction projects are starting to gather momentum.

Immediate economic impact of the quake was severe, but relatively short-lived
The devastating earthquake and subsequent tsunami drastically altered Japan’s economic landscape. Manufacturing and power generating facilities in the disaster area sustained huge damage, and the secondary effects of power shortages and supply-chain disruptions on production became increasingly evident. Personal consumption also suffered a significant negative shock.

In the following months, however, the Japanese economy plotted a v-shaped recovery as supply-chain disruptions were quickly resolved and manufacturing facilities were brought online ahead of schedule. Production normalised in most industries and sentiment indicators rebounded. Furthermore, companies and individuals cut their electricity usage, thereby avoiding massive power blackouts. As a result, Japan in isolation recovered well and the prospect of further supplementary budgets and substantial reconstruction demand enhanced the economy’s near-term growth prospects.

As the post-quake market impact eased, external conditions deteriorated
However, while domestic supply-side constraints eased, external demand factors deteriorated, slowing the pace of Japan’s recovery and impacting negatively on stock performance. Following a strong rebound in the third quarter (annualised real GDP surged by 7.1%), economic activity slowed, with structural fragilities in Europe, yen appreciation and fresh supply-chain disruptions stemming from the floods in Thailand negatively affecting Japanese exports.

While the slowdown in overseas economies and the delayed start-up of reconstruction projects hampered output temporarily, production activity should gradually return to a recovery path. Forecasts for February and March point towards positive growth and are consistent with recent improvements in leading indicators such as the Institute of Supply Management’s New Orders Index for US manufacturers and the Chinese Purchasing Managers’ Index.

Furthermore, the Bank of Japan’s recent move to expand its asset purchase program by ¥10 trillion and redefine its price stability goal has provided a welcome boost to sentiment.

Structural challenges lie in wait
While Japan has made significant strides in recovering from the earthquake, the economy remains deeply affected by the disaster. At the same time, structural issues such as energy policy and the potential for future power shortages, the hollowing out of industry and fiscal deterioration were exacerbated by the events of last March, and require clear strategic policy initiatives from the ruling authorities.

Post-quake market rebound curtailed by events overseas
The events of 11thMarch drastically altered the market landscape. In the immediate aftermath of the disaster, the Japanese market registered its worst two-day decline since the 1987 crash. Initial concerns about the direct effects of the earthquake gave way to fears about radiation leaks from the stricken Fukushima nuclear power plant. Meanwhile, rolling power blackouts and supply-chain disruptions exacerbated the economic impact of the disaster. The post-earthquake impact on the Japanese equity market eased off by early August, however, as industrial production recovered to 95% of its immediate pre-quake level and earnings revision momentum reached a post-quake peak.

As the European debt crisis deepened, we saw a surge in risk aversion among international investors. Against this backdrop, the yen appreciated sharply against other major currencies and Japanese stocks hit fresh year-to-date lows. At the same time, the floods in Thailand and corporate governance issues created additional headwinds.

The investment environment in Japan reached a nadir around August-November. Share prices have since recovered, however, as central banks worldwide, most recently the Bank of Japan, implemented quantitative easing measures and risk aversion eased. Year to date, Japanese stocks have performed strongly in both absolute and relative terms.

Although we may see some level of retrenchment, there are a number of factors indicative of further upside to share prices through the first half of the year:

 increased liquidity resulting from monetary easing worldwide

 the prospect of a bottoming-out and recovery in global economic activity

 the gradual resolution of the euro-zone debt crisis

 expectations of a significant profit recovery by corporate Japan in fiscal 2012

 supplementary budgets fuelling post-quake reconstruction demand

 the oversold level of the Japanese market and its historically cheap valuations

The outlook for the second half of the year is less clear, however. Market activity may be hampered by the imposition of the Volcker rule in July, speculation of fiscal tightening globally in 2013 and a quick pricing in of Japan’s FY12 profit recovery. Furthermore, once public-sector investment peaks in 1H 2012, Japan faces numerous structural challenges.

The outlook for Japan - is now a good time to invest?
While there are issues with establishing a case for strategic investment in Japan, the market sell-offs in 2011 have created scope for Japanese valuations to revert to the historical mean, and we feel that stock-picking opportunities in a number of undervalued cash-rich Japanese companies have been overlooked.

Despite headwinds, at the microeconomic level, Japanese companies have seen a significant improvement in earnings and profitability. They have strengthened their earnings base, improved cost efficiencies and have become more accustomed to coping with persistent yen appreciation. They have also increased their overseas presence, particularly in Asia, adapting to sluggish domestic demand and structural shifts in the global economy.

Meanwhile, cash reserves at listed Japanese companies have risen to record highs and free cash flow generation has improved significantly. In addition to enhancing shareholder returns through buybacks and dividends, companies have wisely been seeking to capitalise on the strength of their balance sheets and the yen to acquire businesses overseas. This strategy has been supported further by the recent expansion of the government’s foreign investment loan programme, which is aimed at curbing yen strength by getting Japanese companies to increase their foreign currency assets.

Furthermore, the Japanese market has finally worked off its valuation premium and now compares very favourably with its own long-term history and its global peers on virtually all main measures.

All this said, investors need to be aware that cheap markets do not always equate to value, because often low valuations are fully deserved. The key then is to be very selective and to seek out those quality companies that are well managed but about which the market, for whatever reason, has become unjustifiably negative. Such instances are comparatively rare, but in the current environment of overall investor nervousness, we believe they certainly do exist.

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