Is Japan Back?

Normally, we wouldn’t get excited about something so hashed out in the mainstream media. But it’s hard to ignore the world’s second largest economy. Chris Mayer explores Japan’s possible resurgence…

When Rakuten, Japan’s largest online shopping mall, quietly acquired a piece of the Tokyo Broadcasting System and announced its intention to merge TBS in Rakuten, it created quite a stir in the Land of the Rising Sun.

This sort of thing was not supposed to happen in Japan. Instead, a kind of forced stability was the hallmark of Japan’s economy. It was supposed to be devoid of the more freestyle elements of American capitalism, such as takeovers and mergers. But that era is over.

The Japanese stock market was once the greatest show on earth. America, indeed the world, couldn’t get enough of Japan. Books extolled how Japan was primed to take over the world. America, these pundits predicted, would soon be a poor vassal in a new Japanese Empire. Come to think of it, you hear arguments along the same lines made today about China.

After the peak in 1989, the curtain fell, and it’s been largely riding the skids since. The Nikkei Stock Average fell to a low of 7,831 in April 2003, a drop of 80% from its high. That seems to mark the bottom.

Since then, it’s slowly crawled out of that hole. Today, it sits at around 13,199 – near four-year highs and a 68% gain from the bottom, but well below the old peak of 38,915.

I first wrote a bullish piece on Japan in my newsletter, Capital & Crisis, in April 2004. Since then, the Nikkei has rallied and Japan has been in the news more. A recent cover of The Economist reads, "The Sun Also Rises." Trading volume in Japan has surged, reflecting an influx of money looking for a stake in Japan’s recovery – everybody from European pension funds to flush Middle Eastern oil barons.

The Resurgence of Japan: Can’t Ignore the World’s Second Largest Economy

Normally, I wouldn’t get excited about something so hashed out in the mainstream media. But it’s hard to ignore the world’s second largest economy. And we may come to different conclusions for investment purposes.

So the question is this: Is Japan’s revival real, or are the seemingly bullish sentiments on Japan premature? To offer a preview, I lean more toward the former. Let me show you the collected evidence, which I believe offers a compelling portrait of an economy on the mend.

The most important changes are those happening on the ground – in individual companies, industries and the banking system. Consolidation of Japanese industry is only one part of the story. The excesses of the prior boom have finally sweated off, like the soft middle of a man newly taking up exercise. In its place, a leaner and more competitive economy is emerging.

Once saddled with bad debt and deadbeat borrowers, Japan’s banks have cleaned up. Today, bad loans are half of what they were in 2001. As a result, Japan’s banking system is ready to expand again. For the first time in seven years, lending in Japan is up, a clear sign that economic conditions are improving.

The real re-emergence is also evident in places like Nagoya, the heart of industrial Japan. The old sunset industries like steel, ceramics, autos, machinery and chemicals are booming.

The Resurgence of Japan: Not Competing with China

How does high-cost Japan compete with low-cost China? Easy. It doesn’t. Japan has moved up the food chain, producing sophisticated high-end products – things like hybrid car engines and robotic machinery for industrial use.

So far, South Korean and Chinese manufacturers have been unable to mimic Japan’s technological savvy. In fact, some of Japan’s biggest customers are other Asian manufacturers.

Then, too, there is the incredible efficiency of Japanese firms. Only in Japan could the construction of a new airport finish two months early and $1 billion under budget, as recently happened in Nagoya.

Bears on Japan fret about the aging population, as if Japan could run out of workers. Taken to laughable extremes, Japanese demographic forecasts point to an ever-diminishing population such that there will only be three people left by the year 3000. These kinds of projections never come true, because demographics change – albeit slowly. Already, Japan is finding workers from overseas. Employers are increasingly hiring migrants from places like China and Brazil.

Bears may also point to Japan’s reliance on foreign oil – it imports nearly all of its oil. This is true, but the point misses the larger picture. Japan’s reliance on oil has fallen. As recently as 1991, oil supplied 57% of Japan’s energy. Today, it stands at 49% and is heading lower.

Japan has turned to alternatives such as nuclear power, coal and natural gas. Even so, the Japanese are much more efficient in their consumption of energy. On a per capita basis, Japan’s energy use is about half that of the United States’.

Another source of nagging doubt about Japan’s stock market outlook: The locals have not yet bought in. Japanese households invest only 8.5% of their assets in Japanese shares. Figuring the locals know better, some use this as evidence that the West is being duped.

Ironically, though, locals can sometimes be the last ones to recognize what’s happening, especially after so many years of disappointment. Look at South Korea. That market has soared 24% this year, among the best in the world. Yet only 6% of Koreans own shares in the Korean market. Only recently has Korean ownership of Korean shares started to increase.

As Christopher Wood, the chief Asian equity strategist at investment bank CLSA, notes, "The longer the Japanese domestics do not buy, the more inevitably they will buy. And when they do, they will do it all at the same time." The lack of domestic buying is another catalyst to take the market higher


Chris Mayer
for The Daily Reckoning

November 10, 2005

P.S. In the coming weeks, I’ll be sending notes to The Daily Reckoning about my trip to China. I hope to give you a ground-floor look at some of what’s happening there and thrash out the investment implications. There is a lot going on, and not only in China. I’m excited about the year ahead. It should be educational, entertaining and – best of all – profitable.

The more things change, the more they remain insane.Chris Mayer is a veteran of the banking industry, specifically in the area of corporate lending. A financial writer since 1998, Mr. Mayer’s essays have appeared in a wide variety of publications, from the Daily Article series to here in The Daily Reckoning. He is the editor of CrisisPoint Trader and Capital and Crisis – formerly the Fleet Street Letter.

"Alan Greenspan has welcomed the ability of new technologies in financial markets to reduce transaction costs, to allow the creation of new instruments that enable risk and return to be divided and priced to better meet the needs of borrowers and lenders, to permit previously illiquid obligations to be securitized and traded, and to make obsolete previous divisions among types of financial intermediaries and across the geographical regions in which they operate."

The words are those of Donald Kohn, a man who is a Fed governor, a Greenspan aficionado, an attendee at the Jackson Hole confab in August, and probably (only history will tell) a jackass. He and other speakers elaborated a view, which is both new and old, and completely mad: that technology, innovation, globalization and sophistication have made the financial world a safer place.

We noted the evidence of these modernizations in this space over the last few years and gave them some precision only a few days ago. Since Alan Greenspan took over at the Fed, levels of debt throughout the entire financial system have increased greatly. Over the past decade, adds Dr. Kurt Richebächer, "consumer debts are up 121%, to $10.7 trillion," while real consumer income was either stagnant or falling. More alarming, but also more puzzling, is the increase in derivatives. The ISDA reports that international interest rate and currency derivatives outstanding shot from $865 billion in 1987 to $201.413 trillion in 2005. It is these last figures to which Mr. Kohn refers. These sophisticated financial instruments make it possible for 8,000 hedge fund managers, and thousands more money managers spread all over the world, to go long, short, and upside down all day long.

In theory, with so many more ways to protect themselves, and so many people involved in the financial markets, the system is more stable. When one position tanks, the loss is absorbed by thousands of investors and financial intermediaries all over the globe. But in practice, the money managers all tend to do the same thing. They know that they will lose their jobs if they under-perform their peers; if they go along with everyone else, on the other hand, they may all blow up…but it wasn’t their money anyway.

Financial institutions make their money by originating and selling what are inherently risky positions. In a bank-dominated financial system, the banks themselves, and ultimately a banker, stood to gain or lose as the loans came due. If the banker made bad bets, he could be disgraced, broke, and out of business.

But in this new, more sophisticated world, financial institutions create derivative products and sell them to hedge funds. Once sold, the salesmen earn a commission and the risks are transferred to the buyers. The funds have every incentive to take risks. If they win, the managers take a bit part of the gains. If they lose, they suffer no personal penalty. Ultimately, no one knows how risky the system is, or who, exactly, stands to lose if it implodes.

We don’t know any more than anyone else. We only note that the more stable and safe a financial system becomes, the more investors are lured to take risks, and the more financial intermediaries are encouraged to develop new products to help investors part company with their money. Eventually, the lack of perceived risk creates a situation in which real risk is greater than ever. When people think there is no risk, for example, they see no need to save money. But when people have no savings (savings rates in America were recently negative) they are most at risk, and often driven to react in panicky, desperate ways. That is, where we find ourselves today.

It reminds us of the geo-political situation prior to the Great War. That too, was a period of fast innovation, stability, technological progress and globalization. Thinkers at the time came to the same conclusions about these things as Donald Kohn, 100 years later. The world had become too sophisticated for war, they said. Interlocking treaties would serve to prevent any nation from firing its cannons first. New technology made war too devastating to contemplate (or, taking the opposite side of the argument…many argued that technology made it possible to fight a war with few casualties!). And modern, globalized markets meant that war no longer made sense. That was the point made by Norman Angell, in a celebrated book of the time. A nation’s wealth was built on factories and trade, he pointed out. War was now out of the question, because it would destroy wealth.

But in 1914, began the most deadly and expensive war in human history.

More news from our team at The Rude Awakening…


Eric Fry, reporting from Manhattan:

"Faithful Rude Awakening readers may have been slightly less shocked than most investors. Back in early August, your editor took a few pot-shots at Toll Brothers’ stock…that happened to hit the target."


Bill Bonner, back in London with more insight…

*** Gold refuses to cooperate. We wait for it to fall. Instead, it rises – up another $5.20 yesterday. Will we ever seen $450 gold again?

*** The homebuilders are falling. Look at a chart of Toll Brothers, for example, says Steve Sjuggerud. It tells us that the property boom is over – whether retail prices have caught on yet, or not.

Homebuyers are reacting to higher interest rates. The bull market in bonds ended in June of ’03, according to our guesses. Since then, the major trend in bonds is down. Which means, the cost of borrowing is up…which means; it is now more expensive to buy a house, even if the price is unchanged.

*** This week’s bond auction at the Fed brought more bad news. Typically, foreigners buy about half the bonds on offer. This week, foreign buying took up only 21%. Bond prices fell again.

*** A few months ago, our old friend John Mauldin asked for our thoughts. He was putting together a book with a collection of writers, among them Gary Shilling, James Montier, Dennis Gartman and of course, John himself. We were honored to be included in the group. And while we can’t remember what we wrote, we’re sure it was heavy enough to make a bruise if it fell on your toe. The idea was for each writer to try to imagine himself on his deathbed with only a few moments of life remaining. He could pass on "Just One Thing" – a single idea or thought that he considered of critical importance. What would he say?

The book is now out, available at, says John. We’re looking forward to our copy, too.

The Daily Reckoning