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Monday, July 24, 2006

Cautious Views on Japan

Of all the markets in the world (outside of gold), we are probably most bullish on Japan. GaveKal Research, while positive on Japan, provides some insightful words of caution. There are specifically two points of caution: 1) Did Japan shoot its own recovery in the foot again? and 2) corporates might struggle because of higher labor costs. Read on.


Did "They" Do "It" Again?

With the "they" being the Japanese policy makers and the "it" shooting any recovery in the foot. Let us explain:

As we never get bored of pointing out, structural bear markets and deflationary busts only happen when policy makers commit one, or several, of what we call the "five cardinal sins". The five sins are: 1. Protectionism, 2. Tax Increases, 3. Increases in Regulation, 4. Monetary Policy Mistake, 5. A War.

The common thread behind these five policy mistakes is that, when committed, they reduce the returns on invested capital and consequently, asset prices are pushed lower. And this puts the financial sector in trouble, etc...

Now why do we return to this long-held, and long-exposed, belief? It is not because of the failure of the Doha trade round (though that is a worry in itself). Instead, we return to the cardinal sins because they have proven to be a solid roadmap when navigating the treacherous Japanese financial markets.

Indeed, looking back at the past fifteen years, it often felt as if Japanese policy makers, if given half a chance, did their best to commit any, or all, of the above mistakes and shoot any recovery down. For example, in 1996, Japan raised taxes. In 2001, the BoJ allowed the growth rate of the Japanese monetary base to move into negative territory while the world was already experiencing a recession.

Which brings us to today and the recent announcement by a panel of LDP lawmakers of a plan to cut the maximum legal interest rates Japanese consumer finance and credit card companies are allowed to charge their customers from the current 29.2% to around 20%. This increase in regulation (which has taken the consumer finance companies completely by surprise), would likely cut off at least 9 million borrowers (out of the current 20 million) because the lower rates would make it unprofitable for consumer finance companies to take on the risk of the loans. A study by Waseda University cites that a restriction of the maximum interest rate to 23% would likely knock off 0.36% points of GDP. Needless to say, a restriction to 20% would make the economic hit even more dour.

Beyond the possible hit, there is also the threat that increases in regulation will help push more of the consumer lending underground, towards loan-sharks and Yakuza, and that the weakest consumers end up paying even more extortionate interest rates for the money they want. In other words, the LDP's good intentions could very well come to naught!

In any event, the threat of new regulations on the consumer finance industry, and thus on consumption is very real (the stocks have definitely taken it seriously). This is something that bears watching.

Labor & Profits in Japan

The recent weakness in Japanese equities (the Topix is down -10.3% so far this year) indicates that the appetite for Japanese assets is definitely falling. This is a marked change compared to the end of last year, when Japan was everyone's favorite market.

Over the past six months, we have suggested a number of possible explanations for this weakness, including the change in monetary policy (see The Importance of Japanese Liquidity Flows), the fact that Japanese companies could once again be placing market share over profitability (see Japan's Capital Spending Boom), the likely slowdown in global growth (our latest Quarterly) and even the possibility that Japan's policy makers are back to doing what they do best: nipping in the bud any recovery (see previous page). But there is yet another possible explanation for the weakness in Japanese equities: the fact that corporate profits are set to struggle because of rising labor costs.

In our past decade of following Japan, we have seen many age-old relationships break down spectacularly. One relationship that nonetheless remained solid was the one between Japanese corporate profits and Japanese over-time worked. And for a simple reason: A company facing a slowdown in sales (whether because of deflation or weak economic growth) can usually either: a) take the hit on its profit margins or b) maintain its margins and reduce its costs (i.e.: layoff some of its work-force and cut capital spending).

When Japan experienced its deflationary bust, laying off workers was simply not an option (because of institutional rigidities). Companies that faced a slowdown in sales could thus either cut capital spending (hereby jettisoning future competitiveness) or take the hit on profit margins. More often than not, the second option was chosen. Equity markets tanked and productivity sank. In turn, this meant that when the economy picked up, companies rarely hired new employees in the economic upswing (they already had all the employees from the previous cycle that they had not fired). And if demand accelerated further, companies would typically prefer to ask their workers to work overtime rather than increase payrolls (having just gone through the negative experience of excess payrolls). Thus, when we would see overtime accelerate, we could feel fairly confident that:

a) Demand in Japan was accelerating and
b) Corporate profits would pick up.

But in the past few quarters, this relationship has completely broken down. Overtime work has been re-accelerating (red line, RHS) while corporate profit growth is stuck in the low single digits and still decelerating. So why this breakdown?

The explanation might be found in Japan's increasingly tight labor market. Indeed, in the past two years, the unemployment rate in Japan has fallen from 5% to 4%. Now granted, this 4% unemployment rate seems high compared to the levels prevalent in the 1970s, 1980s or even early 1990s. But, since then, the Japanese economy has evolved from one where industry was the main driving force of growth to one where services are increasingly the new job creators. And in an economy driven by services, the minimal unemployment rate might be somewhat higher than in an economy driven by industry.

With that in mind, the Japanese labor market might be tighter than it would appear at first glance (a possibility which would help explain the BoJ's tightening). The recent rise in Japanese wages (wages had been declining for four years), also points to an increasingly tighter labor market. With a tight labor market, companies might be asking employees to work overtime not because they want to... but because they have no choice if they want to keep up with demand. Will this be good news for corporate profits? Over the long term, it should. But in the short term, disappointments might be around the corner.


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