The Japanese stock market represents one of the most attractive opportunities among the world's major markets, while demand remains strong in the US and China - its key export markets
an attractive stock market
Until recently, all of the economic data coming out of Japan indicated that the economy was in recession, which is probably why this stock market is now cheaper relative to the US than it has been for many, many years. However, the Japanese economy has significantly shifted up a gear in my view and now ranks among the most attractive in the world in terms of where we expect to see returns come from in 2005.
This expectation is borne out by recent news indicating that the recent soft patch in economic data is now behind us. Industrial production has bounced; inventory levels (the amount of stock that companies hold that gives us an indication of how long it will be before they need to reorder), although still excessive in the technology sector, are under control overall. Also, the level of unemployment has resumed its decline and I am encouraged by signs that land prices are finally falling to more realistic levels - something that unlocks value and provides an additional boost for the economy.
well placed to capitalise on exports
While the fact that domestic news in Japan is improving is of course encouraging, it is not the key to my optimistic assessment of the prospects for the region.
Why not? Put simply, because demographic trends represent a major long- term drag on the domestic economy. Japan's working population is shrinking by around 0.7% every year and unless there is a sudden change in immigration policy this trend is unlikely to reverse soon.
This represents a significant drag on domestic demand over the long run and leads us to believe that the prospects for the Japanese stock market are likely to remain closely tied in with those elsewhere in Asia.
My optimism about the Japanese economy and the stock market relates to the fact that a large proportion of companies in Japan rely on exports for their profits, and therefore the fortunes of the Japanese economy are tied to the state of demand in its largest export markets, namely the US and China.
In particular I remain very positive on the long-term prospects for China, where inflation and credit growth data have recently been better than expected.
benefiting from
chinese growth
Many of the companies favoured in my portfolio are positioned to benefit from the continuation of strong Chinese economic growth. It's a fact that the impact of China filters all of the way through the Japanese economy.
Shipping, for example, is one area which has seen a strong impact from improving demand from China, as have the steel industry, chemicals and the oil refiners.
Among my favourite holdings geared into China is Mitsui, a large Japanese industrial firm, where robust Chinese economic expansion has enabled it to achieve rising returns from its wide portfolio of industrial investments in the region.
Looking more generally at good examples of exporters we like, as Japan's industrial production picks up I believe that machinery manufacturers look set to be among the best performers in 2005. Japan's carmakers remain one of my favoured areas on a long-term view. Toyota and Honda are two well-known examples. Their success boils down ultimately to being well-run companies that build products that are reliable, well engineered and attractive, thereby helping them build market share abroad.
more than just an export story
Of course an economy cannot prosper on export success alone. Fundamentally, a reasonably healthy labour market and strong corporate finances are required. The good news is that both show signs of improving in Japan. Unemployment was frighteningly high by Japanese standards in 2002 and (after a spell of decline) it was on the up once again in the summer of 2004.
This raised concerns among investors that the economic recovery would be short lived. However, unemployment has since declined once again and we are confident that this trend will continue through 2005.
As a result I expect Japanese consumers to start to spend more aggressively in 2005 and, with this in mind, the next move in the portfolio could well be to increase exposure to firms that are well placed to benefit from this.
Positive developments in employment and the related recovery of real estate should help banks and insurance companies, which is likely to mean we may add further to our positions in these sectors.
transforming corporate landscape
On the subject of company finances, Japanese companies have faced the difficult task of boosting profitability in the face of weak growth and falling prices. They have done this by conserving cash and undertaking extensive restructuring. It is this total transformation of the corporate sector which underpins my positive outlook on Japan.
While good and bad companies remain, the progress that Japanese corporations have made in terms of addressing the needs of shareholders has been remarkable.
The positive trend in dividend payout rates is one practical example of this. As companies balance sheets improve, so does the health of the banking system and all in all Japan's gradual emergence from its lost decade continues.
The opinions are those of James Pulsford as at 20/06 and may not reflect those of DWS Investments. The views expressed in this article should not be construed as advice on how to construct a portfolio or whether to buy, retain or sell a particular investment. The value of an investment on overseas equities will rise or fall with any movement in exchange rates. Please remember that past performance is not a guide to future returns. The price of shares and the income from them may fall as well as rise and investors may not get back the amount originally invested. Issued by DWS Investment Funds Limited, One Appold Street, London EC2A 2UU. Authorised and Regulated by the Financial Services Authority.
For issue to professional advisers only. Circulation must be restricted accordingly and exclude private investors.
james pulsford
James Pulsford, manager of the DWS Japan Growth fund, recently added a new accolade to his long list of credentials, when he was awarded a maximum Fund Management AAA rating by Standard & Poor's. James already holds a AAA rating from Forsyth/OBSR. He has more than 20 years experience investing in Japanese companies and is a fluent Japanese speaker having worked in Tokyo for more than 10 years before returning to London in 1999.
key points
• Japanese shares are cheap relative to stock markets such as the US.
• Demand in China looks set to support the fortunes of Japanese exporters.
• Positive employment trends may see an increase in banks and insurers.
