Japanese Prime Minister Naoto Kan's narrow Tuesday victory over Ichiro Ozawa for the leadership of the Democratic Party of Japan wouldn't normally get investor pulses racing – after all Japan has had five prime ministers in four years.
However, the Bank of Japan's heavy intervention in the currency markets this week confirmed my view that this political twitch was really very different.
The upshot: As investors, we should pay attention … and should look to increase our allocation to Japanese stocks.
Big Spenders No More
Ozawa, known as the "Shadow Shogun," was originally a powerful politician in the Liberal Democratic Party that dominated Japanese politics for 55 years. He split with the LDP in 1993, reformed the opposition and became the power behind the DPJ. He served as the DPJ's secretary general from 2006 to 2009, although he was forced by scandal to resign before its election victory in September 2009.
The reason we should pay attention is that Ozawa's defeat may end the dominance of the big-spending interests in Japanese politics and allow Kan to get down to the hard work of correcting Japan's deficit and debt problem. This will take several years, but even in the short term may result in faster growth for the Japanese economy and – interesting to us as investors – the final end of the 20-year bear market in Japanese stocks.
You see, Ozawa earned his "Shadow Shogun" nickname for his arm-twisting, backroom deals. He used his power to promote Japanese infrastructure spending, forming alliances with the big construction companies that funded his own political career, as well as the careers of those around him.
This "cash splash" philosophy has been a big problem for the Japanese budget and its growing debt. Ever since Japan's stock-and-real-estate bubble burst in 1990, leader after leader has attempted to prop up the economy with major infrastructure spending.
The only exception was the short (2001-2006) stretch under then-Prime Minister Junichiro Koizumi, when the spending flow was cut back and some attempt was made to balance the budget.
Alas, this budgetary enlightenment wasn't to last.
When the global financial crisis struck in 2008, Japan – like other countries – resorted to repeated "stimulus" initiatives, which is finance-speak for infrastructure spending. The result has been an inexorable climb in Japan's debt load, which this year reached 217% of gross domestic product (GDP).
At that level, something has to give. Only twice in world history – Britain after 1815 and again after 1945 – has a country with a higher debt level managed to bring it down without default.
According to the National Bureau of Economic Research (NBER), public-debt levels that reach or exceed 90% of GDP become highly problematic. And a recent research study – conducted by economists Kenneth S. Rogoff of Harvard and Carmen M. Reinhart of the University of Maryland – found that for countries with debt-to-GDP ratios "above 90%, median growth rates fall by 1%, and average growth falls considerably more."
The Wrath of Kan
Kan, who took office in June, realized that policies had to change, but was damaged by DPJ losses in July's upper house elections. And when he refused to resort to the same sort of backroom wheeling-and-dealing that had been the hallmark of "Shadow Shogun" politics, Ozawa challenged him for the party's leadership.
The Tuesday (Sept. 14) election was the showdown between Ozawa and Kan.
Having seen off Ozawa, Kan should now have a reasonable run of power in which he can take steps to repair Japan's economy. And it's pretty clear what those steps need to be.
Public spending needs to be cut back, so that the budget can be reduced, preferably without large increases in taxes. At the same time, the danger of deflation – made worse by a steadily rising yen (which reduces Japanese exports by making them more expensive, even as it reduces the prices of imports) – must be fought off.
The Bank of Japan (BOJ), following Kan's instructions, achieved progress on this front on Wednesday (Sept. 15): It intervened heavily in the foreign-exchange market, first in Tokyo, and then – when it opened – in New York.
One estimate puts the BOJ's first-day intervention at $11.6 billion. The intervention pushed the Japanese yen down by more than 3% against the U.S. dollar. That will help Japanese exporters – and at the same time will limit deflationary forces in Japan's domestic economy.
All of that, in turn, should give Kan some room for budget cuts.
The Tokyo stock market reacted favorably, rising more than 2% on the news of intervention. By Japanese standards, it's currently very cheap, at less than 25% of its 1990 value and it remains near the bottom of its trading range since 2000. It has bounced little since its bottom last year, unlike other global markets.
Thus, Japan's stock market currently appears to have better rebound prospects than many other markets around the world. So if you haven't got any money in Japanese stocks, you should probably boost your allocation.
Let me be clear: Even with this week's developments, Japan isn't destined to become the world's next white-hot market; given what transpired this week, I'd say my rating has shifted from 5.0 out of 10 to about 7.5 or 8.0.
Besides, Japan is still the world's third-largest economy, and its prospects seem likely to improve. And let's not forget, it is an export powerhouse in the fastest-growing region in the world – Asia.
For a general exposure to Japan, you should go for its exchange-traded fund (ETF), the iShares MSCI Japan Index (NYSE: EWJ). The fund has $4.5 billion in assets, so it's certainly large enough for ample liquidity, while its expense ratio is low at only 0.55% of assets. Trading at 15 times earnings, the fund is reasonably priced. Plus, it's got a 1.6% dividend yield.
Of the big exporters, I most like Honda Motor Co. Ltd. (NYSE ADR: HMC). It's trading on only 9.9 times trailing earnings, or only 17% above book value, and it hasn't had to deal with the scandalous product-quality problems that have dragged down rival Toyota Motor Corp. (NYSE ADR: TM) in the U.S. market. With the revival of global automobile markets in full swing, and its orientation towards fuel-efficient models, Honda is well placed to take advantage of the increasing wealth of East Asia.
Japanese banks are a real bargain. Mizuho Financial Group Inc. (NYSE ADR: MFG), for example trades at only 60% of its net asset value (NAV) and at only 5.5 times earnings – a far lower rating than its U.S. or European peers. With the Japanese economy expanding in a healthy manner, and its domestic real estate problems far in the past, Mizuho looks like an excellent value, and the market is likely to realize this soon.
Finally, Japan's small-company sector will likely benefit greatly from an economic revival. To benefit, investors should consider the Fidelity Japan Small Companies Fund (FJSCX). This well-established, no-load mutual fund concentrates on Japan's smaller companies, which are often difficult for U.S. investors to invest in directly. As foreign funds go, its expense ratio of 1.1% is quite reasonable.
[Editor's Note: Money Morning's Martin Hutchinson continues to make money for his readers by being right on the money with his predictions.
Just look at some of his most recent market calls. Earlier this year, just a week after Hutchinson recommended Germany, the European keystone reported much-stronger-than-expected GDP growth. He recommended Chile back in December, and three of the stocks he highlighted have posted double-digit returns - and one is up nearly 25%. He again recommended Korea - which analysts were downgrading - only to have the traditionally conservative International Monetary Fund (IMF) come out with an upgraded forecast that projects solid growth for that Asian Tiger for this year and next.
A longtime international merchant banker, Hutchinson has a nose for profits - as evidenced by his unerring ability to paint a picture of what's to come. He's able to show investors the big profit opportunities that are still over the horizon - while also warning us about the potentially ruinous pitfalls hidden just around the corner.
With his "Alpha Bulldog" investing strategy - the crux of his Permanent Wealth Investor advisory service - Hutchinson puts those global-investing instincts to good use. He's managed to combine dividends, gold and growth into a winning, but low-risk formula that has developed eye-popping returns for subscribers.
News and Related Story Links:
- Money Morning News Analysis:
Japan's Move To Push Down Yen Gives Its Exporters a Boost Against Global Rivals.
- The Sydney Morning Herald:
'Shadow Shogun' promises a cash splash for leadership.
Democratic Party of Japan.
Liberal Democratic Party.
- Money Morning Analysis:
Will America Choke on its Own Debt?
- The Bank of Japan: