This commentary was written by Bill Witherell, Cumberland’s Chief Global Economist. He joined Cumberland after years of experience at the OECD in Paris. His bio is found on Cumberland’s home page, www.cumber.com. He can be reached at Bill.Witherell@cumber.com.
The heads of state of the G20 countries are gathered today, April 2, in London for their meeting. Last week when I was in Paris, I was asked in a CNBC Europe interview if the upcoming meeting should be called a G2 meeting, with the US and China being the only important participants. Readers of the financial press could be excused for thinking that it will really be a meeting between three parties, the US, China, and the European Union. It was only yesterday when the presence at the G20 table of the second-largest national economy (at market exchange rates — third-largest in purchasing power parity terms), home to the second-largest equity market, received some press recognition. That would be Japan. The lead story in the Financial Times reported Japanese Prime Minister Taro Aso’s remarks stressing support for strong fiscal action by the major economies to counter the global recession and criticizing Germany for not understanding this. The lack of attention being paid to Japan probably reflects both the country’s current economic problems and the unsettled domestic political situation. International investors, however, should not ignore Japan.
The Japanese economy has tumbled into the most severe downturn in Japan’s postwar history. Japan did not have a bubble in its real estate markets. Nor did its financial institutions appear to have excess leverage in their loan portfolios, nor heavy emerging-markets exposure. But crashing exports due to the global credit crisis and aggravated by a strengthening currency tipped the economy into the steepest decline of any major economy in the fourth quarter of 2008. GDP fell at a -12.7% seasonally adjusted annual rate.
The decline has continued in the quarter just completed. In February, Japan’s exports dropped -49.4% y/y, following a similar -45.9% decline in January. Industrial production in February was down a striking -38.4% in February from the year earlier. Yesterday’s release of the Bank of Japan’s so-called “headline” Tankan diffusion index for large manufacturers, a business conditions index, revealed a plunge to a record low of –58, from -24 in December. Japan is in a deep economic recession, with a return to deflationary conditions from which it had only begun slowly to emerge.
While this imported economic crisis could not have been avoided, the ability of Japan’s economic policy makers to respond has been hampered by the country’s domestic politics, which have been in a state of turmoil for several years. There have been three prime ministers since Koizumi stepped down in September 2006. The ruling Liberal Democratic Power must face a parliamentary election by September. It appears to be doomed to defeat, and observers question whether Aso will be able to hold on to his position until the election. Efforts by the government to provide fiscal stimulus have encountered stiff resistance by the opposition Democratic Party of Japan, which controls the upper house of the Diet. Nevertheless, the three successive fiscal stimulus packages introduced since August 2008 total about 2% of GDP. Prime Minister Aso said earlier this week that he has given instructions for a further economic stimulus package “based on bold thinking” to be developed before mid-April. The dimension of the plan is expected to be on the order of $200 billion.
Given the political inability of the government to act rapidly and effectively, the Bank of Japan, usually kept in the shadows, has moved to center stage and has taken some well-directed actions. Its competence reflects the fact that the BOJ has, in my view, the best economists working in Japan’s public sector. But the Bank’s independence from the government is more limited than is the case in most other major economies. Measures to provide liquidity include purchases of up to 3 trillion yen of commercial paper and 1 trillion yen of corporate bonds by September. The Bank will also be increasing its purchases of government bonds and of shares held by eligible banks.
Looking forward, the OECD, in its revised forecasts released earlier this week, sees a recovery in domestic demand in Japan coming only in the second half of 2010. They see overall GDP growth in 2010 at -0.5%, following a decline of -6.6 % for the full year 2009.
Japan’s equity markets, as measured by the MSCI index for Japan, dropped by -17.4% in the first quarter of this year. This was substantially greater than the -11.1% decline in the MSCI index for the US equity market. The decline in the MSCI index for all Europe also was less, -15.2%, but the Euro Zone’s decline was slightly greater at -17.8%.
While Japan’s domestic investors have continued to shun the market, some international investors appear to be starting to find valuations in the Japanese market attractive, despite all the negative factors noted above. Should the Japanese yen weaken from its current high level (as seems likely to us) and the new fiscal stimulus program, together with increased quantitative easing by the Bank of Japan, be implemented and be successful in encouraging Japanese consumers and investors, the OECD’s projections could well prove to be too pessimistic. To cite several other plus factors, Japan surely will benefit from the expected resumption of strong growth in China and the anticipated beginning of a recovery in the US in the second half of 2009.
At Cumberland Advisors our international portfolios currently have underweight positions for Japan. We will be looking carefully for signs of an improvement in prospects there. However, for us the time to increase exposure to this important market has not yet arrived.
Bill Witherell, Chief Global Economist, email: firstname.lastname@example.org
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