Look to Japan in the decade of equity


David Roche
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Japanese equities are at the start of a sustained bull market that in the next two years will take the Nikkei well above 20,000 from its current 14,000 level.

For the first time in more than 15 years in Japan, the appetite for higher-risk assets such as equities is set to rise. There are three reasons for this, one cyclical and the others structural. First, the Japanese economy is on a sustainable growth path. Real wage growth is now positive, and employment is recovering as businesses use their much-improved profitability to expand. Second, the political environment for enterprise and investment has been altered by the dramatic victory of Junichiro Koizumi in the September general election. The passage through parliament of the law enabling the privatization of the post office sets the scene for a new era of economic reform. Reformists in the ruling LDP are now in the saddle. This sets a tone for more deregulation and enterprising investment, which is great news for Japanese equities. The generation gameThe third reason will work itself out in the long term, but is probably the most important for a sustained bull market in Japanese equities – demography. Japan’s population is rapidly ageing. The post-war baby boomers are starting to retire. Already in excess of 20% of the population are more than 65 – a much higher proportion than in any other OECD country. That will imply a lower savings rate and more consumption of goods and services, as older people stop saving and start spending. Also, the older generation will be handing over its wealth to a new generation. And this generation is much more consumer-oriented and ready to spend. But it is not just consumer demand in Japan that will benefit. Higher-risk financial assets will too. Younger Japanese are much more prepared to invest their savings in high-return assets. At the moment, that has meant shifting away from cash deposits in the post office into Japanese government bonds and investment trusts oriented towards assets denominated in foreign currencies. It is these investment trusts that have put so much of their money into US government paper and corporate bonds. As a result, net inflows from foreigners buying Japanese equities have not been accompanied by an appreciation of the yen, as is usually seen in rallies of the Nikkei. Indeed, the yen has weakened against the dollar in the past few months. Yen weakness is really a product of dollar strength. All the major currencies have weakened against the greenback, whose trade-weighted index has risen 5% this year. However, as yen interest rates start to rise in 2006, Japanese households and their investment trusts will start to switch back into domestic assets. I reckon that is likely to be equities. Japanese households have a very low share of their financial wealth in equities compared with those in other OECD countries. That’s a product of the old social market model. Hot propertyJapan is the ideal risk diversification from inflated Anglo-Saxon housing bubbles. A decade or more of falling land and house prices has also made Japanese residential property highly affordable. The mortgage market remains relatively underdeveloped and ripe for expansion. Above all, Japan’s new generation of homeowners want much better housing than their parents put up with. So Japanese real estate is set to boom along with equities. And, as household wealth rises with real estate prices, that will boost domestic demand. For the moment, with US interest rates trending upwards, that has meant dollar deposits. So the current rally in the Nikkei, led by foreign purchases of Japanese equities, has been counterbalanced by savings and investment flows towards the US, particularly into higher-yielding bonds. This, together with banks playing the same yield pick-up trade, is causing the yen to weaken against the dollar.

However, once interest rates stop rising in the US and start rising in Japan, those flows will switch back into Japanese assets, particularly equities, as households look for better returns. We are entering the decade of equity for Japan and a long-term Nikkei bull market. This will eventually reverse the current bout of yen weakness.  

Japanese household real earnings growth
Source: Datastream