Japan's economic recovery from its 1990s slump seems more strongly based today than ever. Output is growing, unemployment is falling, and even consumption is staggering to its feet — though not enough for the Bank of Japan to dare another rate rise in January.
For the financial markets, it is a benign period, with the stockmarket rising, plenty of demand for new capital, and a vigorous round of M&A getting under way. There is every sign that those trends will continue or intensify in 2007.
THE SHOE SHINE man at one of Tokyo's leading hotels sees a new sheen on Japan's future, and on his own.
In his tiny workshop-cum-office in the hotel, he inconspicuously makes far more money than most would imagine — enough, it seems, to feed his fondness for Mercedes cars, château wines and trading the stockmarket.
"We have come through the worst," this early baby boomer says, head down over another $15 shine-up. "The good times are coming back again."
With these words, he is speaking also for many more experienced participants in and observers of Japan's financial markets. Those who experienced the turmoil of Japan's burst bubble and the ensuing financial crisis of the late 1990s have shaken off their anguish and are now embracing Japan's new economic and financial landscape.
In this latest panorama, there are plenty of new boom areas. In the corporate world, mergers and acquisitions are a huge growth industry, with domestic mergers, including hostile bids, featuring large. There is a growing confidence in boardrooms across the land, leading to more overseas acquisitions.
Going hostile, going overseas
In 2007, M&A will surely again be one of the most dynamic elements in Japan's financial markets. The Nikkei newspaper reported on January 5 that 45% of the participants in a survey cited M&A as the most important issue of 2007.
Japan Times reported on December 13 that the number of announced merger deals rose 1.9% in the first 11 months of 2006, after soaring 23% in 2005 and 28% the year earlier, citing data from Recof Corp, a Japanese firm that tracks M&A activity. Although this might on the surface seem disappointing growth, the size of deals is considerably larger and the type of deals much more varied.
One such was the hostile bid by Oji Paper for Hokuetsu Paper Mills. Although this collapsed in July, the ramifications are being felt by company directors across Japan.
The Nikkei also reported on January 10 that there has been a sharp rise in demand for shareholder identification services from listed firms that want to fend off potential hostile takeover bids or attempts by investment funds and other entities to acquire big stakes.
The foreign ownership of Japanese companies — overseas investors held about 20% as of the end of September — is cause for concern among many boards of directors. With the arrival in May 2007 of a new tax code that will permit triangular mergers, with foreign companies then able to take over Japanese firms through stock swaps, this percentage is only likely to grow.
Analysts at Nikko Citigroup argue that more hostile bids, especially from overseas, are also likely to spur more rescue mergers by white knights and management buy-outs — as well as defensive efforts by companies to stave off bids by buying back stock and raising dividends.
In the world arena, Toshiba's acquisition of Westinghouse Electric of the US in October and Nippon Sheet Glass's purchase of the far larger Pilkington of the UK, which transformed NSG into the world's largest maker of sheet glass, were the two standout deals of 2006.
The largest domestic deal was the ¥1.2tr purchase of Vodafone Japan by Softbank, a heavily leveraged deal in the early spring that was refinanced through a ground-breaking whole business securitisation late in 2006 — the world's largest such deal.
Private equity buy-outs are also thriving, building on the success of the Vodafone deal and early LBOs in 2005 such as the World Corp delisting. Massive new domestic funds are adding to the cash pile, as are the leading US and European funds, and banks and other lenders are extremely eager to finance their acquisitions.
Buy-out funds seeking to invest in Japanese companies have earmarked about ¥4tr ($33bn) in 2007, up 240% from two years earlier, according to the Nikkei, as pension funds and other institutional investors seek higher yields through private equity investment.
JGBs still pouring out
In the debt capital markets, Japanese government bond (JGB) issuance continued at record levels, and the government redoubled its efforts to diversify the products it offers and broaden its investor base, with a notable push to garner more global demand.
The government hopes to put the brakes on the growth of JGB issuance. Finance minister Koji Omi said in early December that the government aimed to cut net new issuance of JGBs for the fiscal year starting April 1 2007 by more than ¥4.4tr to around ¥25.5tr ($216bn).
Lower down the state hierarchy, government agencies are being reformed and in some cases privatised, while municipalities' finances are being liberalised, leading some local governments to seek credit ratings.
In the domestic corporate bond market, investors are receptive to new products and longer maturities as companies seek to reshape their balance sheets and hedge against rising interest rates.
The lights of the Samurai market were dimmed by a change in clearing and settlement procedures that offended the US tax authorities, sidelining US issuers. But a resolution to the problem in the autumn has already resulted in the return of several US household names, such as Bear Stearns and Goldman Sachs.
In the overseas debt capital markets, Japanese names have again been noticeable by their absence, with one big exception — the major finance companies, led by Toyota Motor Credit Corp — and banks seeking regulatory capital.
The megabanks have again been the dominant force overseas, supported by new entrants such as Shinsei Bank and the hitherto enigmatic Norinchukin Bank.
Development Bank of Japan, Japan Finance Corp for Municipal Enterprises and Japan Bank for International Cooperation flew the flag for Japanese government credit with isolated deals in the international markets, accompanied by the Metropolis of Tokyo, but for the most part they were content to fund cheaply in the domestic market.
Securitisation sets new records
It was a bumper year for securitisation — Deutsche Securities estimates that issuance surged 27% to the equivalent of about $95bn.
The flow of assets and structures has become more diverse than even the most ardent optimists had hoped for, even without the exceptional ¥1.45tr whole business securitisation for Softbank Mobile.
Residential and commercial mortgages are the most prevalent assets, the former accounting for more than half the total volume last year. Consumer finance issuance was sapped by regulatory concerns over permissible rates of interest, but those should be cleared up by legislation this year.
Japan's commercial property market has staged an impressive recovery in recent years, and the residential sector in the urban centres has perked up markedly.
Just five years old in September 2006, the Japanese real estate investment trust (J-Reit) sector is set to welcome its 41st listed member in February. The sector has a total valuation of more than $39bn and was trading in December at a weighted average dividend yield of 3.5%, or 1.8% over the 10 year JGB yield.
J-Reits ride the property boom
With the J-Reit market spanning an ever more diverse array of property sectors, investors have a growing choice.
Buyers are exercising that choice, so that the biggest and most keenly followed trusts are trading at slender yields (2.6% in fiscal 2006 for Nippon Building Fund, the largest J-Reit at just over $6.1bn) and huge premiums to net asset value (63% for NBF).
Meanwhile, the smaller and less favoured trusts are facing weak valuations (yields of up to 6.4% and discounts to NAV of more than 16%), making it hard for them to attract fresh equity capital and make purchases. The bigger, more fashionable trusts enjoy the lion's share of investors' money and acquisition opportunities.
The result is that many market participants expect consolidation in the sector to drive revaluations, as the bigger trusts try to buy their smaller and weaker competitors. At the same time, easing of regulations will make it possible for the J-Reits to buy overseas assets for the first time.
The J-Reit market in some ways encapsulates the dynamism of the Japanese financial markets. This new group punches way beyond its weight in the equity capital markets, as the bigger trusts raise ever larger sums of fresh money for acquisitions. These deals in turn help drive liquidity in the commercial property market, also a core focus for many private investors in Japan and for funds from across the globe.
Stockmarket climbing steadily
As 2006 came to a close and 2007 began, there was plenty of optimism for the Japanese stockmarket, with expectations that the Nikkei 225 should climb past 18,000 by the end of this fiscal year on March 31. On January 24 it closed at 17,507 — well within striking distance.
Rising corporate earnings, M&A and the potential for the yen to rebound against the dollar as the BoJ raises rates are the main factors supporting investors' high hopes.
Nevertheless, while there is general optimism, few expect the market to race ahead. In its outlook for 2007 dated November 15, the Goldman Sachs team of analysts and economists headed by Kathy Matsui was cautiously optimistic about the year ahead.
The team noted the disappointing performance of the stockmarket in the second half of 2006, pointing out that apart from the "dramatic" 43% return that the Topix posted in 2005, the main reasons for lacklustre performance included disappointing macroeconomic data, subdued earnings guidance, and a weak supply/demand balance caused by a large volume of equity issuance.
Although the Goldman team had revised downwards their earlier projections for the market, they noted that as Japan has been trading at a discount to the US and European equity markets in terms of enterprise value/Ebitda and P/BV multiples, the market should be well supported on the downside.
The team also identified four catalysts that could help the market outperform their expectations in the year ahead. These included: better than expected domestic demand and inflation; improved earnings confidence; lower equity issuance; and additional corporate restructuring activity through M&A.
The result could be the Topix hitting about 1,800 by the end of 2007, although this is lower than Goldman's previous forecast of 1,900. Investor enthusiasm in early January helped the Topix close at 1,738 on January 24.
Merrill sees consumption rising
In its 2007 outlook report dated December 20, the Merrill Lynch team comprising economist Jesper Koll, equity strategist Masatoshi Kikuchi and fixed income strategist Mitsumaru Kumagai take a more optimistic perspective on the stockmarket, supported by their up-beat assessment on the macroeconomic outlook for Japan in 2007.
The team argues that "spurred on by very easy financial conditions and a record cash surplus, corporate Japan is relentless in its focus on raising productivity and improving global competitiveness". And the authors predict "more aggressive investment in both human and productive capital" that will help consumer demand to rebound.
Taking a fairly bullish stance on the equity market, the Merrill team predicts that the Topix will register a year-end 2007 figure of 1,900 and 1,950 by the end of fiscal 2007. Based on the firm's top-down profit forecast of low double digit profit growth for listed companies in fiscal 2007, that would put the market on a p/e ratio of 18.
Merrill expected companies in the first section of the Tokyo Stock Exchange to "generate double digit recurring profit growth again, thanks to recovery in the global economy, an improvement in the terms of trade, and stability in the yen's trade-weighted value".
On the latter point, the rising interest rate environment leads many to project a rise in the yen, a rise from ¥121.55 to the dollar on January 24 to at least ¥114 to the dollar by the end of March.
As they expect domestic consumption to rise, the Merrill analysts are bearish on JGBs and expect the 10 year bond yield to rise to 2.1% by the end of 2007. That would be accompanied, they believe, by two rate rises of 25bp, so Merrill recommends that investors adopt bear flattening strategies.
The bank also observes that demand for jobs already exceeds supply and increasingly companies are hiring full time, not part time workers, helping the unemployment rate to fall from a peak of 5.6% to 4.1%.
For the first time since 1997, both nominal and real wages started to rise in early 2006. The result is what Merrill sees as a "key risk" for the 2007 outlook: higher than expected wage inflation pressure.
However, the Merrill team has confidence in the policymakers that Japan's new prime minister Shinzo Abe has assembled since taking office in September. They argue that in "sharp contrast to the 1990s, Japanese monetary and fiscal policy making is marked by great pragmatism" and therefore that the "risks of an erratic tightening of monetary or fiscal policy remain very low".
Fears of BoJ paranoia
Others, however, see policymakers as a risk factor. Nikko Citigroup analysts Kiichi Murashima, Jin Kenzaki and Masafumi Yamamoto surmise in a January 5 outlook report for 2007 that the greatest risk to Japanese stocks comes not from external factors such as the US housing market, or from yen strength, but from Bank of Japan policy decisions.
Nikko warns that the BoJ has a history of raising interest rates after the market peaks, noting that it did so in 1990 and in 2000 and that share prices subsequently declined sharply.
The Nikko Citigroup authors therefore caution that if the BoJ "continues to raise interest rates without regard for the equities market, we cannot rule out the risk of a decline in share prices, particularly in domestic-demand and financial stocks that would suffer especially from higher rates". They add that "we can only hope that the BoJ has learned sufficiently from its past mistakes".
The 10 year bond yield stood at 1.74% on January 12, with the market leaning towards the likelihood of the BoJ raising rates. But when the next meeting came on January 18, the committee was split six-three in favour of leaving rates unchanged. BoJ governor Toshihiko Fukui admitted that there was disagreement on the likely growth in consumption. By January 24, the 10 year JGB had firmed to 1.655%.
According to economists and market watchers at Daiwa Securities SMBC Europe in a January 12 report, the core problem remains the BoJ's scepticism that deflation has ended and that prices will begin to rise.
In Daiwa's analysis, the Japanese economy lost momentum in the second half of calendar 2006, taking most observers, including the BoJ, by surprise. The firm believes that explains why, a year since the end of its zero interest rate policy, the BoJ has still only raised rates once — in July.
Daiwa expects Japanese growth to remain disappointing, citing a range of indicators, including manufacturing sentiment, a substantial high-tech inventory problem, consumer lethargy and continued wage deflation.
But the Nikko Citigroup team paint a more optimistic picture. They see an economy moving into its seventh year of growth, a corporate sector that has largely eliminated the three excesses of capacity, debt and employment, rising corporate profits, export growth and rising consumption driven by growing household disposable income.
Even though the bank expects consumer prices to rise only 0.2% in 2007, they warn that the BoJ will raise interest rates several times this year.
Nikko calls GDP growth at 2.4% in both fiscal 2007 and 2008, up on the expected 1.8% of 2006. They believe these factors will push JGB yields up only as far as 2.1% in the second half of 2007.
That fits with an outlook range of 1.54% to 2.22% reported by the Nikkei newspaper from a survey of investors it took in nearly January. During calendar 2006 the 10 year JGB traded in a range of 1.405% to 2.005%.
Domestic buyers take the lead
In the equity capital markets, 2006 was a remarkable year, with numerous highlight IPOs, new and secondary equity offers and jumbo equity-linked issues in the public arena.
In the private domain there were yet more privately underwritten convertible bond and equity warrant financings, although this private end of the market diminished in popularity as the year wore on.
For 2007, Nikko Citigroup researchers predict a continuation of the trend of changing demand for Japanese equities that has prevailed since the equity bubble burst in the early 1990s.
Foreign buying of shares dependent on domestic demand, such as real estate stocks and banks, have driven valuations of these sectors fairly high, while export-related stocks such as machinery, cars and pharmaceuticals remain low.
Foreign investors are likely to be the largest buyers again in 2007, Nikko reckons, but investment trusts and companies themselves (through buybacks and cross-shareholdings) will also increase their overbought positions. Individual investors and trust banks will continue to be net sellers, for structural reasons.
The team believes that investment trusts, particularly dividend-oriented investment trusts, will become the dominant domestic buyers, stimulated by the October 2007 privatisation of Japan Post. They could even replace foreign investors as the main buyers of Japanese equities, taking over the role of leading the market higher, which foreigners played from 2003 to 2006.
The result is that the authors surmise that domestic-demand and financial stocks, which have been favoured by foreign buyers, "will be replaced as the stars of the market" by stocks with strong dividend growth potential.
In keeping with Japan's economic recovery, the rise of its financial markets and their growing complexity and sophistication, financial services minister Yuji Yamamoto announced in London on January 8 that Japan plans to create an international financial district in Tokyo, resembling the City of London.
In the year ahead, Japan's financial markets hold more promise than they have for more than a decade. The time for reflection and caution are over. The time for action has come. l