Ending 2007 with one of the world's worst performing stock markets, Japan is facing a crisis of confidence. Valuations have already fallen to levels not seen in decades. What happens over the next few months will be key in determining what direction the country's stock market takes.
Morgan Stanley's SICAV Japanese Value Equity Fund employs an active, bottom-up, relative value strategy. Its key focus is to identify companies that are undervalued compared to the market.
'Our long-term approach emphasises companies that exhibit attractive business fundamentals such as positive free cash flow, product competitiveness and a sound financial structure, yet are inexpensive relative to the market,' said John Alkire, managing director and chief investment officer for Japanese Equities at Morgan Stanley Investment Management in Tokyo.
'The portfolio is not managed to specific risk objectives or to a targeted tracking error. However, we monitor and manage individual stock risk, valuation risk, diversification and liquidity risk on an ongoing basis.'
Although the Japanese stock market has rebounded since mid-March, the country's economy has suffered for a long period.
The currency has been stabilising and equities in the United States have increased in value. But economic indicators such as employment and consumer confidence have continued to decline. A steadily rising consumer price index (CPI) and durable goods orders have also not been encouraging. There are fears that the economy might weaken further.
Several factors have contributed to the country's economic woes. Domestic consumption and economic growth have been weak. Business investment has fallen. Exporters have been hurt by the weak US economy and the rising yen. 'Japan is arguably facing a political crisis with the Diet [parliament] having been involved in a lengthy and agonising debate before finally appointing Masaaki Shirakawa as governor of the Bank of Japan, while Prime Minister [Yasuo] Fukuda's approval rating is continuously falling, leaving little confidence and uninspiring stewardship,' said Mr Alkire.
'This is particularly pronounced at this juncture of the economic cycle with the strengthening yen and slowing economy in need of stimulus and reform. Corporate profits for the 2007 financial year, ended in March, will be announced over the next few weeks, and companies will likely be revising their earning guidance for the following year based on a stronger yen and weakening global economy,' Mr Alkire said.
'With Prime Minister Fukuda's approval rating falling from 50 per cent to 26 per cent, this will likely result in a reorganisation of the current leadership. In addition, the Japanese stock market, which has its constituents populated 65 per cent by 'economic sensitive' sectors, appeared in 2007 to be discounting a global economic slowdown given the index's sensitivity to economic activity,' Mr Alkire said. 'Under such circumstances, demand for Japanese equities remained weak from non-resident investors while domestic institutional and retail investor participation in the markets was virtually non-existent.
'Foreign net selling, reflecting such concerns, rose to 1.3 trillion yen (HK$97.71 billion], the highest since the stock market crash in 1987,' Mr Alkire said. 'From the middle of March, global equity markets rose as the FOMC [Federal Open Market Committee] lowered the federal fund's rate, easing some credit concerns and a large emergency bail-out of a brokerage [Bear Stearns] in the US sparked both short covering and bargain hunting for oversold securities.'
The first quarter of this year proved to be an extension of last year's credit crisis. It was punctuated by highly volatile stock prices and a rapidly waning appetite for risk by investors all over the world.
'As such, Japanese equities acted like an exclamation point to the concerns over the global economy and remained out of favour with asset allocators and domestic institutional and individual investors,' Mr Alkire said.
'This bearish news fed throughout most of the quarter on fears of continued losses for US subprime mortgages, the collapse of bond guarantees and massive debt writedowns.'