Gareth Morgan, director of Gareth Morgan Investments
The recent lurch in Japanese financial markets is one more step on the road to oblivion for the Japanese economy as we’ve come to know and admire it. For years now the apologists have argued that Japan is different and applying Western economic convention when assessing its economic health is just inappropriate. This somewhat mystical interpretation of the Japanese disequilibrium has just about run its course now.
Once international capital markets became deregulated the duration of Japan’s special financial market arrangements was always going to be finite. No amount of “special reasons” can justify the pitiful rates of return which Japanese assets yield even to this day. For those rates of return to have any degree of international comparability, property prices in Japanese cities still have to halve again (having already done so since 1990), and equity prices likewise have to fall further – unless of course corporate earnings bound ahead sometime soon, an unlikely prospect.
Japanese PE’s have barely retreated from their “special Japanese” levels of 80 to 100 despite the fall in share values. The fall in corporate earnings has been equally dramatic. So unless an investor is confident that earnings are about to rebound – a thesis which is optimistic bordering on reckless – equity valuations in Japan have yet to shed their “special Japanese” underpinning and adopt more internationally conventional norms. Unlike other major markets, investors in Japanese shares are still happy apparently to receive a minimal dividend yield – a bold undertaking given the poor quality of Japanese corporate earnings and the increasing reliance of the firms on debt, as their asset holdings devalue.
The “special Japanese” reasons for inflated PE’s includes a faster than normal depreciation of assets (which depresses their reported earnings), absence of equity accounting (which omits profits from their cross shareholdings), and a restricted supply of scrip to the market due to the stable cross shareholdings between corporates. All three excuses have turned to mush. The depreciation claimed has been every bit real, as firms have not managed to earn an acceptable return on their large investment outlays of the late 1980’s; equity accounting would be now bringing in large losses from other firms owned or part-owned; and the “stable” cross shareholdings have begun to be ditched as firms rush to avoid devaluing assets on their balance sheet.
Japanese share values will inevitably approach international norms. Taking cognisance of both the low rate of return from operations which firms’ assets are applied to, and the counter influence of a low real bond rate in Japan, this suggests that share values have to fall another 40% from present day levels – which are already 75 % lower than their 1989 highs. A Nikkei of under 9,000 then seems about right.
The problem of course is getting there, or what euphemistically is referred to as the “transition”. Japan’s rigging of the financial sector, with its insidious government influence has slowed the inevitable, but won’t prevent it. Indeed their intransigence could be seen as fuelling a severe, rather than orderly adjustment. Sayonara.