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2011-06-15 AXA IM Weekly Comment Japan - V-Shaped Rebound Confirmed

2011-06-15 AXA IM Weekly Comment Japan - V-Shaped Rebound Confirmed

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Research & Investment Strategy
Weekly Comments 547 – 15
th
June 2011
Japan: V-shaped rebound confirmed
www.axa-im.com
AXA Investment Managers Paris, a company incorporated under the laws of France,having its registered office located at – « Cœur Défense » Tour B – La Défense 4 – 100, Esplanade du Général De Gaulle – 92400 Courbevoie.registered with the Nanterre Trade and Companies Register under number 353 534 506a Portfolio Management Company, holder of AMF approval no. GP 92-08, issued on 7 April 1992
Key points
 
Sharp recovery in the pipeline, due to inventoryreplenishing and private consumption.
 
Growing threat of power shortages during thesummer.
 
Taxes will probably be raised in 2012 and 2013.
 
The Japanese market seems to have discounted alot of negative news but is not outright cheap.
 
Start moving back into the market—at least if youare an investor who does not follow a benchmark.Three months after the terrible earthquake of March 11,which ravaged North-eastern Japan, the country is justnow starting to bandage its wounds. A V-shapedrecovery in the coming months is not doubtful in theleast, but the consequences of the catastrophe, both onthe political and economic fronts, are giving rise to fearsof a delay over the summer.
A deep and destabilising though temporaryshock
Japan’s national accounts for Q1 cast a stark light on theeconomic impact of the earthquake. Quarterly GDP fellby 0.9% even as a rapid recovery was shaping up inJanuary and February. It comes as no surprise thatinventories are way down and household consumptionhas ground to a halt.
The Japanese recovery is gathering pace
3035404550556020042005200620072008200920102011-12-10-8-6-4-20246
 %  y o  y
Manufacturing PMI indexGDP [RHS]
Source: ESRI, Datastream, Bloomberg, AXA IM 
 All economic indicators confirm that the trough wasreached in April and that the recovery began in May. Theimprovement is quite palpable in the manufacturingsector, with a PMI reading that moved once again above50 points in May. The forecasts from the Minister ofIndustry give reason to hope that the rebound will extendinto June at least, with high monthly growth rates (8% inMay and 7.7% in June). Still on the supply side, servicesrebounded in April, correcting for 40% of the declineobserved between February and March.In the short term, the economic rebound is obviouslybeing driven by the recovery in production for the sectorsthat suffered the most from the earthquake. Thereplenishing of inventories will also play a critical rolebecause the latter, already substantially diminishedduring the financial crisis, had not yet been fully restoredbefore the earthquake.On the demand side, the decline in business activitylevels led to substantial job losses (-600,000) betweenFebruary and April. A plunge of this magnitude inemployment over two months had not been seen inJapan since the first oil crisis of 1974. Initially, the badnews on jobs focused all of the fears of Japanesehouseholds, but the real threat to the morale of theJapanese consumer is actually more in terms of incomegrowth over the medium to long term. Indeed, theearthquake weighed adversely on corporate earningsand, in this context, it is difficult to anticipate higherbonuses for wage earners in the months ahead. Thisbeing said, the contraction in payroll, related to a one-offshock, should only be transitory. The economic recoverywill be accompanied by a rise in employment and this willin turn provide more solid support for consumption.We can also expect to see an uptick in privateconsumption in the run-up to the possible, if not probable,VAT hike in 2013 and the impact on income in 2012. Wewill revisit what was until recently a taboo subject; butthere is a very good chance of seeing a repeat of thescenario observed in late 1996–early 1997. At the time,the Hashimoto government’s decision to raise the VATfrom 3% to 5% led to a sharp rise in private consumption just prior to the actual hike, followed by a deepdepression in the two quarters that followed.Therefore, it seems to us that consumer spending willremain hesitant in Q2 but will thereafter become a driverof growth, particularly at the end of this year and into the
 
 
Japan: V-shaped rebound is confirmed
 –
15
th
June 2011
 
Research & Investment Strategy – AXA Investment Managers_____________________________________________ 
The written material contained herein was completed on June 14 2011 – 2 – 
 
beginning of next. Vehicle registrations in April and Maywere in line with this scenario, revealing a certain wait-and-see attitude despite the recovery underway.
Risk of power shortages this summer risingsteadily
The summer, which corresponds to peak demand forelectricity, is increasingly a cause for alarm. Theconsequences of the earthquake are being felt not only inthe regions devastated by the disaster, but throughoutthe country. Many businesses have in fact moved theirproduction westward, and this has led to durably higherthan normal demand for power. At the same time, thenuclear power plants that have been shut down formaintenance have not yet reopened. In mid-June, 37reactors out of 54 (which is 14% of total electrical powerproduction capacity) were shut down, with four additionalreactors possibly joining them in early July.So the risk of shortages is real, and not just in andaround Tokyo. In early April, we estimated the elasticityof GDP to electricity production to be around 0.2, and weconcluded then that this would shave anywhere from 0.2to 0.4 percentage points off GDP growth in Q3, based oninadequate production just for TEPCO. Taking intoaccount the nuclear power plant closures across thecountry, the impact could be as high as 0.6 percentagepoints in the worst case.
The risk of a debt spiral is pushing thegovernment to think about higher taxes
Beyond the risk of power shortages, the magnitude andthe workings of the government reconstruction programfor the devastated regions will also have an impact on therecovery. The first budget add-on was adopted in May,equal to 0.9% of GDP. This plan will be totally financedthrough the reallocation or the reduction of expendituresalready programmed, to avoid the risk of a newdeterioration in the country’s sovereign debt. Theprincipal rating agencies have clearly warned thegovernment against debt-financing the reconstructioneffort. So there should not be any additional demand, andstimulation of the economy will be based solely on themultiplier effect of expenditures.A second stimulus plan, the magnitude of which could bebetween 2% and 3% of GDP, is currently being workedout and could be adopted sometime in August. It nowseems to be a foregone conclusion that this second planwill be financed via the issue of reconstruction bonds,which would be distinct from traditional bonds forconstruction and for financing the deficit. One of thespecific features of these reconstruction bonds lies intheir repayment structure, which would come throughdedicated tax revenue. A report will be submitted to thegovernment on this subject at the end of June. A VATrate hike is an increasingly likely scenario under thecircumstances.This second stimulus plan will be decisive in determiningthe speedy return of Japan’s GDP to growth, though theinstability at the head of the executive branch could slowdown the process. The main question at this pointconcerns early elections if PM Naoto Kan were to resignbefore a vote is taken on the plan, at a time when hisparty is more divided than ever. Although hypothetical,this scenario is weighing adversely on investors’ morale.
Appealingly priced equities? Not so fast!
Surprisingly, international investors kept buying theJapanese stock market at least until very recently, whilstdomestic investors moved to the sidelines as earningsexpectations of the Kabuto-cho tumbled. We think thatthis movement is not over yet. Earnings will most likelyremain depressed until i) the full impact of the pastrecession has been digested, ii) the currency starts toweaken significantly, and iii) the Asian recovery showssigns of traction.Yet a big chunk of negative earnings seems to be pricedin. Different classic valuation measures suggest that themarket offers value for the long-term investor. Currently,Japan trades at 5.7x price/cash flow compared to 8.9x forthe entire MSCI universe.However, on a more forward-looking metric such as thePEG ratio, the Land of the Rising Sun trades almost atpar with global markets (1 standard deviation below itsaverage). This clearly shows the degree to whichinvestors doubt current earnings and earningsprojections. We also know, however, that Japaneseearnings are more a function of volume than anythingelse. If production recovers, earnings should find a solidunderpinning and thus offer a decent floor to currentvaluation. We therefore suggest increasing the weightingof the Japanese market in the months to come, at leastfor those investors who are not tied to a benchmark.
Conclusions
A V-shaped recovery is likely, but the bottleneckcaused by electricity production woes and politicaluncertainties could disrupt the rebound, at leasttemporarily, over the summer.We think that GDP will shrink in 2011 by 0.3%,followed by a rebound of 3% in 2012. Longer term,the inevitable rise in tax pressures will weigh, at leastinitially, on the outlook for growth, especially as thecountry’s potential growth converges more and moretoward zero.
Hervé LIEVORE & Franz WENZEL

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