Japan: V-shaped rebound is confirmed
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.
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