Japan's Politics Shouldn't Derail Its Economy: Profiting from the New Prime Minister

By Martin Hutchinson
Director of Global Investing Research

The unexpected resignation of Japanese Prime Minister Shinzo Abe on Sept. 12 spooked the Tokyo stock market. But as the dust clears, it's obvious that investors shouldn't worry.

The new prime minister, Yasuo Fukuda, isn't about to change an economic policy that is currently working quite well. That's especially true when that policy is very much in line with his longstanding personal beliefs. And because Fukuda is likely to further the economic policies of his predecessor, Japan will continue to represent an island of stability in a global economy that's still riding the subprime waves.

For shrewd investors, that scenario spells opportunity. And we can suggest several ways to play it. Let me explain ...

What Really Matters in Japan

There's really only one issue that Japan investors should be tracking: Public spending. Until 2001, Japan had expanded the public sector like madmen trying to spend their way out of their decade-long recession. That not only didn't work; it left Japan with a debt load equal to 170% of Gross Domestic Product, and a public spending deficit equal to about 8% of GDP.

In 2001, Junichiro Koizumi took over. In addition to a real fondness for Elvis Presley, he had a high respect for free-market capitalism and an aversion to expanding the public sector. He brought the annual deficit down, and real growth resumed.

Abe, who took over in September 2006, continued Koizumi's policy and produced an excellent budget last December, which promised a surplus by 2011. The problem was that Abe wasn't all that great at running a government. He lost several ministers to scandal, one to suicide, and the ruling LDP party did poorly in the midterm elections in July. And at a mere 52, he may have been too young for tradition-laden Japanese tastes.

The new guy, Yasuo Fukuda is 71, a "proper" age for a Japanese prime minister. He was said to be a moderate - meaning no visits to the Yasukuni shrine and better relations with China. Although his age might suggest that he favors public spending, I don't think that will be the case. Here's why...

Like Father, Like Son...

You see, Yasuo Fukuda is the son of Takeo Fukuda - Japan's prime minister from 1976 to 1978. He was also considered to be the father of the 1980s Japanese boom. He was an opponent of the corrupt big spender Kakuei Tanaka (1972-74) who gave Japan lots of infrastructure, 34% inflation, and the Lockheed bribery scandal. Conversely, Takeo Fukuda cut the budget deficit, reduced inflation, and laid the foundation for the long 1980s boom.

Significantly, Daddy Fukuda also gave Koizumi his start. Koizumi got his first political job as Fukuda's secretary in 1970, and the two became close - close enough that Daddy Fukuda was best man at Koizumi's wedding. Yasuo Fukuda himself was in Koizumi's cabinet for three years and is a good friend of Koizumi. Thus his father's political tradition and his family's closeness to Koizumi strongly suggest Yasuo Fukuda is not about to reject Koizumi's tight budget policies. Just because he's 71 doesn't mean he's stupid!

The opposition is calling for an early general election, but since the LDP has a two-thirds majority it doesn't need to call one until 2009. Fukuda may decide to call an election next spring but, presumably, only if he thinks he'll win it. Japanese public spending and debt should stay controlled.

Issue #2 Under Control

The other big issue in Japan is interest rates. Short-term rates have been close to zero for far too long and need to be around 2% or so, in line with the economy's growth potential. Japanese savers are getting ripped off, and it's about time that changed. And with lots of Japanese nearing retirement age, the country's savings are huge.

Bank of Japan Governor Toshihiko Fukui has been trying to push short-term interest rates up, but hasn't been allowed to raise them since they went to 0.5% in February. Abe was worried that a rise would be politically unpopular. If Fukui raises them, probably to 0.75%, at the next Monetary Policy Committee meeting October 11, you'll know two things:

  • Fukuda realizes higher short-term rates are a good thing.
  • And he believes the subprime mortgage crisis is irrelevant to the Japanese economy, which remains in pretty good shape.

The stock market may well dip as rates rise, but that will be a short-term reaction. In the long run higher rates mean a stronger economy, a stronger yen, and probably more foreign and domestic money coming into the Japanese market.

Outside the world of Japanese politics, the market's recent drop was largely caused by the subprime mortgage crisis, to which Japan has almost no exposure, probably the lowest of any major economy. Since Wall Street, the epicenter of the problem, hasn't dropped much, it seems unfair that innocent Japan has fallen more.

The one genuine reason for the drop is that the yen has been strong recently, moving from 120 to 114 against the dollar, and likely to strengthen further, particularly if Fukui raises interest rates. As the dollar is weak overall you probably don't want to buy companies exporting to the U.S., since their profit margins will be squeezed. Three suggestions therefore:

  • streetTracks SmallCap Japan ETF (NYSE:JSC.) which invests in smaller Japanese companies, which are mostly domestic and can benefit from continued growth in the Japanese economy without being buffeted by international problems.
  • Kirin (OTC:KNBWY:PK), Japan's largest brewery. It's traded on the dreaded "Pink Sheets" in New York, but has a market cap of $12.5 billion in Tokyo. Kirin's over 20 times earnings, so a bit pricey, but it has focused its growth on East Asia and Oceania, which looks the way to go.
  • Third, Japan's largest investment bank Nomura Holdings (NYSE:NMR), whose share price has suffered recently because Western investors don't like the industry - or its modest holdings of subprime U.S. mortgages. Nomura is however dominant in the domestic market and reasonably priced at 15 times earnings.

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