Friday, September 7, 2007

How vulnerable is Japan?

The Japanese stock market has underperformed other world markets in the recent global
correction largely because of: 1) the perception that the Japanese economy and corporate
sector remain more vulnerable to a US slowdown than other economies, and 2) the
overwhelming influence of foreign investors, which account for nearly 60% of average
daily turnover in the stock market.


In our report titled Stress-testing Japan to slower US growth, dated August 29, 2007, we
said that a 1% decline in US consumption growth in 2008 (from our US economists’
current baseline forecast of 2.1% to 1.1%) could reduce Japanese GDP growth by 0.4 pp,
but still above the 2% level in 2008E. However, the risk scenario is if US consumption
slows by 2%, Japanese GDP growth could fall to a below-trend level of 1.5%.


In terms of profit exposure, similar to Taiwan and Korea, Japan is also vulnerable to
weaker US demand. However, our sensitivity analysis suggests that if total overseas sales
of TSE1 non-financial firms (which accounted for 27% of total sales as of March 2007)
declined by 10% yoy, the negative impact to operating profit growth would be -3.9-5.0 pp.
Given our current top-down operating profit growth estimates of 10% in FY2007E and 8%
in FY2008E, profits could still grow, albeit at a more modest pace. The stock market’s 12%
decline from its July 9 peak seems to be discounting a scenario of declining profits ahead;
however, given our expectations of steady Asian/European demand as well as stable
domestic demand, we believe reality is likely to prove more benign.

Foreign selling diminishes, domestic investors testing the waters
For September, we expect a tug-of-war between concerns over US housing and credit on
the one hand and anticipation of Fed easing on the other to cause market volatility to
persist in the near term. Other near-term factors to watch for will be the central bank
actions (FOMC on September 18, BOJ MPM on September 18-19) as well as 3Q results of
overseas financial institutions.


In terms of recent flows, foreign selling appears to have run its course for now. Following
four consecutive weeks of net selling since late July (totaling over Y1 trn), foreigners
returned as modest net buyers during the week ending August 24 (Y11 bn). Market
momentum in September will depend heavily on the risk appetite of foreigners, in our
view.


Meanwhile, domestic investors (including individuals, investment trusts and corporates)
have been net buyers during the recent correction. The yen’s recent surge appears to have
dampened enthusiasm among Japanese retail investors for foreign currency-denominated
assets. According to Ministry of Finance data, net sales of foreign currency-denominated
bonds reached Y1.5 trn in August (from the week of July 29 to the week of August 24),
marking the highest level of liquidations since February 2007.


Although we doubt that Japanese retail demand for offshore assets will disappear, at the
margin, continued yen strength could suppress appetite for such instruments and possibly
lead to more purchases of domestic equity products, especially those offering high
dividend yields.