Japan's Six Major Bank Groups Report Falling Profits

Consolidated net income for Japan's six major bank groups was down 34% in the fiscal year ending 03/08, while operating profit also fell 3.7%. This is the second year of declinng profits. In addition to significant write-offs for subprime-related losses, commissions from sales of mutual funds, which had been seen as a significant source of new profit growth, have fallen off significantly after the passing of a new financial transactions law and stricter "know your client" rules, as well as the sell-off in Japanese stocks to March of this year. The weak economy is also resulting in higher credit costs because of SME (small and medium-sized enterprise) defaults.

Moreover, the profit rebound in 03/09 should be modest because of continued credit costs, weak loan demand and limited prospects for loan-deposit spread expansion as the BOJ sits on its hands and frets about a slowing Japan economy as well as the risks to global growth.

BOJ's Shirokawa Says Japan's Economy Is "Clearly Slowing"

The BOJ decided to leave rates at 0.5% because Japan's economy is "clearly slowing". Waning corporate profit growth is slowing capital expenditures, production is flat and materials costs are sharply higher, which is also negatively affecting personal consumption. Inflation in consumer staples is particularly noticeable, while companies are finding it difficult to transfer all of higher input costs to final selling prices. In addition, the BOJ sees the risks to the global economy remaining to the downside.

This is quite a different spin than interest rate traders were trying to project, and throws cold water on the conjecture than inflation in Japan will somehow stimulate domestic consumption, as well as lead to higher loan-deposit spreads for the banks, thereby boosting their profits.

Softbank Drops Plan to Issue Preferred Shares with No Voting Rights

Softbank, a favorite among individual Japanese investors, has dropped a plan to issue preferred shares with no voting rights because its individual investors think they should instead increased dividends or offer a stock dividend.

The decision puts a crimp in the Tokyo Stock Exchange's plans for listed companies to take advantage of the Company Law changes that allow the issuance of various types of shares.

Who's Right About US Inflation: Consumers or TIPS?

The University of Michigan survey shows that consumers are expecting inflation as high as 5.2%, while the inflation premium in the TIPs (treasury inflation protected securities) is 2.9%, which is still lower than the 20-year average for inflation of over 3%. So who is right, US consumers or the TIPs?
The answer is that TIPS have chronically underestimated inflation. Traders keep talking about the massive move in commodities being a "bubble" that will burst and bring commodity prices back to earth, while consumers are seeing their take home pay being eroded daily by higher prices of consumer staples like gas, milk, etc. and their net worth in terms of the value of their house slip-sliding away. Prices of consumer durables are falling, but prices of consumer staples are rising--even though a Bloomberg survey shows that US economic growth in the next quarter is expected to be "zero" and the worst since the 2001 recession.

US Recession Buy Indicator?

Mark Hulbert of the Hulbert Financial digest is talking about a recessino buy indicator that may indicate the next big move in US stocks is UP, not DOWN. The recession indicator uses industrial production, manufacturing and trade sales, nonfarm payrolls and personal income as the main indicators. The recession indicator is triggered when each of these is below 6-month earlier levels. Historically, this indicator is a good contrarian call. The S&P 500 has returned an average of 37%, while the gains look more like 106% three years after the signal.

Are the Kiwi's Days as a Favorite Currency Numbered?

The big money (BlackRock and DWS Investment) is now betting against the New Zealand Kiwi, ostensibly because poor economic conditions could trigger the central bank to lower NZ rates (where passbook savings rates are 8.30%~8.50%) as aggressively as they had previously raised them. Currency strategists see the possibility for a two-digit correction, and are suggesting that investors shift to the Auzzie dollar instead.

Both the NZ Kiwi and Auzzie Dollar have been favorite trades Japanese individual currency traders, and Japanese investors own a large chunk of the 70%-plus of NZ bonds that are held by foreigners. These investors were not shaken out as the JPY surged past JPY100/USD and probably won't be shaken into repatriating their money back into yen now. They are more likely, as recommended, to shift into the Auzzie dollar, as overseas yields are simply too attractive versus miniscule yields on Japanese passbook savings.

Shipping Rates Come Roaring Back: How About Japanese Shipping Stocks?

As pointed out in FT Alphaville (The Little and Large of Soaring Shipping Costs), the January plunge in large dry bulk carrier rates was temporary, as shipping rates are now back to record levels. The rise in Capesize rates is sharper, ostensibly due to continued strong demand for coal/iron ore shipping on resurgent demand from steel makers.

While many ships are on order, they are still some time away from being delivered, and thus current supply of ships remains tight, with the dry bulk fleet capacity totalling 132.5 million dead weight tons as of April 1, 2008.

Japan's shipping stocks appear to be lagging this rebound, ostensibly because of fears that soaring energy costs and a stronger yen will squeeze profits. However, we believe that management forecasts may be too conservative, and that continued high shipping rates will continue to support earnings growth.

No Surprise Here: Poison Pills Negatively Correlated to Shareholder Returns

As of the end of March 2008, some 460 Japanese companies had introduced poison pill anti-takeover measures. Of the 110 companies with market cap over JPY10 billion, some 66 or 55% had ROEs (return on equity) below the market average of 10%, while 24 were valued below nominal break-up value (PBR of 1.0X).

Regulations (and Bureaucrats) Are Strangling Japan

In March, according to a Nikkei Net Interactive article dated April 16, 2008, a major bank reportedly received a call from an irate customer. "Who on earth is the law (i.e., a new law regulating sales of financial products and services that mandates identity confirmation for elderly customers in financial transactions) designed for ?", the customer fumed. He went on to complain that "such an inflexible system only repels investors", and are apparently designed more as a means for bureaucrats to avoid being criticized for problems with financial products than as legislation to protect customers. The customer's name was Masajuro Shiokawa, the former Minister of Finance! Introduction of the law has led to plunging sales of mutual fund products OTC at banks, which had become the main sales channel for sales of mutual funds.

Another recent example is the revision to the building standards law in response to the scandal over falsification of earthquake safety data. Stricter safety standards were hastily crafted and rammed through the Diet, without giving developers time to develop new computer software to cope with the new regulations. The result was that new building virtually ground to a standstill for several months, and housing starts have yet to recover.

When the afternoon talk shows began focusing on the "gray area" interest rates charged to borrowers by consumer finance companies, the FSA was closely monitoring the TV gossip, and after the Japan supreme court basically allowed for open-ended claims for refunds of "excess" interest paid, the FSA came out with lower caps on consumer loan rates that slam-dunked consumer finance profits, which had been (and in many ways still are) foreign investor favorites.

Social security has been a major disaster, with successive revelations of local officials blithly committing personal and organizational fraud, and with new social security amendments pushing the medial burden onto the aged who had little understanding of the impact of the new changes.

Consequently, the current stalling of growth in Japan began with a "bureaucrat-induced recession", while the LDP and DJP play mud-wrestling in the Diet.

Japan's Stocks Rise to 4-Month High

Soaring oil prices historically have been bad news for Japanese stocks because high oil prices are bad news for corporate profit. This time, however, the Japanese market has been down for so long that any catalyst (surging oil prices) looks like up. The hope in Tokyo this time is that the US economy will not be as bad as feared.

At the same time, bond prices are weaker because higher oil prices = inflation, which Japan has not seen for nearly a decade. Higher inflation ostensibly means room for BOJ to raise rates at some point this year = widening loan/deposit spreads for the banks = better profits, and thus the banks are reacting positively.

The Yen is also comfortably back below the JPY100/USD "danger" line, easing investor fears that a sub JPY100 yen rate would decimate exporter profit margins.

As for the other items in the usual case against Japan (i.e., a) inept political leadership, b) lack of capital discipline, c) poor demographics, and d) ongoing deflation), "ongoing" deflation is gone, and has turned into undeniable inflation. Most foreign investors agree that inflation is an unequivocal positive for Japanese equities and property. In addition, according to data compiled by Platinum Asset in Australia, growth in adjusted (dividends + share buybacks - capital raising) has outpaced the world and US average since 2002 (at over two-fold increase versus a world average of less than 1.9X and a US average of 1.8X).

So...it looks like the recovery in Japan could continue for the foreseeable future.

(Non) Selection of the Next BOJ Governor: "Rope-a-Dope" Japanese Politics

Rope-a-dope is boxing style used most famously by Muhammand Ali against bruiser George Foreman in their famous "rumble in the jungle". The idea is for the boxer to lie on the ropes of the boxing ring, conserve energy and allow the opponent to strike him repeatedly in hopes of making him tire and open up weaknesses to exploit for an eventual counter-attack.

BOJ watchers began talking about the possibility of selection of the next BOJ governor becoming political football between the ruling LDP (Liberal Democratic Party) and the DPJ (Democratic Party of Japan) a couple of months before the DPJ voted down a succession of two ex-Ministry of Finance candidates for the job. In public, the LDP appeared mystified as to why the DPJ would vote down two apparently qualified candidates (BOJ board member and former MOF official Toshihiro Muto , and Koji Tanami, head of the Japan Bank for International Cooperation and also ex-MOF bureaucrat). Ironically, the two candidates proposed by the DPJ--Haruhiko Kuroda, head of the Asian Development Bank, and Hiroshi Watanabe, head of the Japan Center for International Finance, are also ex-MOF bureaucrates.

The ostensible issue that the DJP has with Mssrs Muto and Tanami is that they are ex-MOF, to which the LDP publicly appears mystified as to why the DJP would unecessarily block the BOJ governor succession process. We believe it is merely "rope-a-dope" politics by both the LDP and the DPJ, hoping that the impasse will have greater political damage to the other party, thereby better positioning them for the July elections. The LDP is hoping the impasse will be perceived by the voting public as an unecessarily obstructionist ploy by the DJP to make the LDP look bad, while the DJP seems to think that the LDP-led Fukuda Administration will lose more points for lack of leadership.

While the lack of a BOJ governor may make foreign investors nervous, the BOJ is now effectively being run by deputy governor Mr. Shirokawa. If Japan really wanted change and an independent BOJ, they would elect former Koizumi Administration reformer Heizo Takenaka. But Mr. Takenaka himself admits he would be unacceptable to both the LDP and the DPJ, as he made a lot of political enemies as Financial Services ministry in trying to clean up Japan's banking system.

Why The BOJ May Not Intervene To Brake the Yen's Surge

The yen hasn't been this strong since 1995, and the sharp upward movement in JPY versus USD of late is cause for concern in Japan, as expressed by Finance Minister Fukushiro Nukaga's concern that recent JPY forex movements are "excessive and Prime Minister Fukuda's warning that the JPY surge against the USD is "not desireable".

Yet Finance vice-minister Shinohara said earlier that current circumstances are different than in 1995 and during past interventions in 2003/2004. Regarding what is different than in 1995, this time the JPY is weak only against the USD, and is actually still near 20-year lows in terms of real effective rates against a basket of currencies. Consequently, we agree with Eisuke Sakakibara, ex-"Mr. Yen" of Japan's finance ministry, when he says that;

1) intervention by the BOJ on behalf of the MOF is unlikely at current levels, because even JPY85/USD equates to JPY110/USD a decade ago. To get to similar inflation-adjusted levels of a decade ago, JPY would have to move to the JPY70/USD range.
2) He does not believe that the US would approve such an intervention.

There may be another fiscal reason. The Bank of Japan (at the direction of the Finance Ministry) creates yen funds for US dollar buying/yen selling by issuing special Finance Bills that are counted as part of Japan's government debt. For example, Japan now has some JPY838 trillion of bonds and borrowings outstanding, or roughly 1.7X GDP. Outstanding Financing Bills(mainly for forex intervention) account for roughly 12% of this. In addition, Japan has been generating consistent gains on its holdings of mainly US treasuries, to the point they are able to transfer several trillions of yen back into the general budget account from gains made on foreign exchange holdings, thereby helping to fund a chronic fiscal deficit.

Thus while Japan has massive foreign exchange reserves of USD979 billion, these are mainly in USD whereas they need to issue new FBs (debt) to intervene by selling yen to brake a very rapid rise.