Bill Sterling is Global Strategist for C.I. Global Advisors LLP, who are one of the fund managers for C.I. Mutual Funds. His reports are interesting and timely, especially for anyone interested in the larger global picture and how it may affect their investments. See our links page for links to C.I. Mutual Funds and other featured mutual funds.
His recent book, "Boomernomics", is highly recommended.

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     World Report 

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March 2000 by Bill Sterling

After a sizzling gain of more than 60% in 1999, Japan's stock market has had a rocky start this year. In the first two months of 2000, the broad market retreated 7% in U.S. dollar terms, compared to a 6% decline in the MSCI World Index. Recent economic data suggests that Japan slipped back into economic decline in the second half of last year, prompting some analysts to fret about a "double dip" recession that could trigger yet another bear market in Japan.

Despite the recovery of the stock market in 1999, we think Japan still faces formidable challenges before its economy is out of the infirmary. Bad debts from the nation's real estate bubble continue to plague the banking system, corporate bankruptcies remain at a high level, and the government is running massive budget deficits. Unemployment remains close to record levels and, despite the recovery in the market, many Japanese remain extremely nervous about their jobs - and for good reason. They know the lifetime employment system is crumbling and that Japanese companies are under pressure to lay off unprecedented numbers of workers.

Added to this mix is the uncertainty created by upcoming elections to the lower house of the Diet, which must be held by this fall. That has created near-paralysis among government policymakers, who have become infamous for ignoring problems until the last minute. Concern is mounting that Japan is backing away from the process of economic reform, with potentially serious consequences to its future economic prospects. Moreover, the government's fiscal problems are prompting bad policy proposals, such as slapping high taxes on the nation's ailing banks.

Does all this suggest that Japan's stock market will revert to its losing ways of the 1990s? We doubt it. There is an old saying in the investment business that "bull markets climb a wall of worry." To be sure, Japan has some major walls to scale. But we also think there are two important factors that suggest Japan could experience a prolonged bull market: (1) technology and (2) financial flows. In our view, these factors suggest that Japan could be a far more rewarding market in this decade than it was in the 1990s.
 

Digital Renaissance?

First, let's consider the issue of technology. We believe the key to Japan's future is whether the country successfully makes the transition from the industrial age to the information age. In this respect, Japan faces issues similar to the ones IBM and Motorola faced during the past decade. Like IBM of the past, Japan's lifetime employment system seems out of step with the realities of the global economy. And like the old Motorola, Japan's reliance on analog technology seems misplaced in a digital world.

After struggling for years, both IBM and Motorola appear to have turned the corner. Gone is IBM's policy of lifetime employment. Motorola has abandoned its analog ways and rebranded the company as a provider of "Digital DNA." For Japan to be successful, we believe it must adopt strategies similar to those embraced by IBM and Motorola.

There are indications that Japan is embarking on the necessary changes to leapfrog into the information age. If we are right, the opportunities for Japanese companies, large and small, could be enormous. Investors with an international perspective are likely to find many attractive investment opportunities in the months and years ahead.

In our view, there has never been a better time for Japan to go digital. Though the PC revolution has largely passed Japan by, the rise of networked computing, Internet appliances, voice-recognition technology and third generation wireless communications represent a golden opportunity for Japan's economy to make a quantum leap into the 21st century. Internet penetration in Japan has now reached critical mass. Roughly 20 million people or 16% of the population is now online. This compares to 100 million people or 33% Internet penetration in the United States. Remarkably, it took only five years for the Internet to reach 10% of the population in Japan. By contrast, it took mobile telephones 15 years to achieve 10% penetration and the conventional telephone 76 years.

Internet penetration could be greater than analysts believe in the future because of developments in Japan's rapidly growing wireless communications sector. There are currently an estimated 56 million cellular phone subscribers (see Chart 2). Cellular penetration in Japan is around 42% today, versus 38% in Europe, 30% in the U.S. and 21% in Canada.

NTT DoCoMo, Japan's biggest cellular operator, is expected to be the first wireless communications company with a third generation (3G) network in 2001. The proliferation of 3G wireless communications equipment could be a huge boon to the Internet. Third generation wireless networks will allows user to connect to the Internet at speeds ranging from 384 kps (384,000 bits per second) to two mbps (two million bits per second). The bandwidth associated with 3G wireless networks will rival that of fixed-line broadband technology such as cable modems and DSL (digital subscriber line).
 
 

With Japan taking the lead in high-speed, 3G wireless broadband services, we believe there could be far more
people in Japan connected to the Internet via a wireless handset than a PC. Our view is supported by NTT DoCoMo's recent experience with the company's i-mode service. I-mode is a low-speed (9.6 kps) data service that was introduced this year and has taken off. The total number of i-mode subscribers is around four million and growing at a rate of 400,000 users per month.

Despite its prowess in manufacturing, Japan is typically not known as an innovator when it comes to technology. Analysts have noted that Japan's big manufacturers have not produced anything truly revolutionary since the VCR, compact disc player and Walkman of the 1980s. That, however, may be beginning to change.

After spending billions of yen on research and development, several big Japanese consumer products companies are preparing to launch a new generation of innovative technology products. According to Matsushita Electric Industrial Co. vice-president, Yoshitomi Nagaoka, almost everything that is connected to a network will be made in Japan.

That may be an overstatement. But there can be little doubt that Japan has the potential to play a major role in the burgeoning global Internet appliance sector. Slated for release in 2001 are an array of products ranging from portable devices able to handle wireless data, electronic mail, Internet access, speech recognition, high-resolution video, and much more. Over the next two years, Sony, Sega and Nintendo (the latter in conjunction with IBM and Matsushita) will launch next-generation versions of their popular video game machines. The next-generation video game machines will have computer-like functionality, expanding the potential market for these products, which already exceeds $15 billion and is growing in excess of 14% per year.
 

Will Japanese Savers Return to the Stock Market?

The other major factor that should help Japan's stock market in coming years is the potential for a major reallocation of the nation's savings out of low-yielding bank deposits and back into the equity market.

Despite the excellent performance of the Japanese stock market last year, it is fair to say that Japanese savers remain highly skeptical about the stock market based on its abysmal performance in the 1990s. As shown in Chart 3, at the end of last September, Japanese households still kept 55% of their assets in bank deposits which currently yield next to nothing. Direct holdings of equities represent less than 8% of Japan's household assets. In contrast, American households currently hold about 43% of their financial assets in equities and only 11% in bank deposits.
 
 

With Japanese households sitting on more than $12 trillion of financial assets, a relatively modest shift of 10% out of bank accounts into the equity markets would represent a potential flow of more than $1 trillion into equity markets. For this to happen, Japanese corporations will have to continue with corporate restructuring and shareholder friendly reforms that will boost their returns to internationally acceptable rates. Otherwise, as Japan's capital markets become increasingly flexible, the money could just flow out of Japan and result in a weaker yen. But the potential for a major reallocation of savings is clearly significant.

It is anybody's guess as to the timing of such a reallocation, but there are some reasons to believe that it could be sooner rather than later. One potential trigger comes from Japan's Postal Savings Bank, which holds over $2.3 trillion in deposits. Nearly $1 trillion of these deposits are in the form of 10-year certificates that were issued in 1990-92 and mature in 2000-02. The first big tranche - about $90 billion - matures this April.

Here's where it gets interesting. Japanese savers who put their money in those 10-year certificates of deposits locked in a respectable yield of 6% in the 1990-92 period. But if they wish to roll over their certificates, they will now receive a shockingly low interest rate of 0.3%. Conclusion: massive amounts of money are going to flow out of the Postal Savings Bank looking for higher yields. Even the Japanese government expects about half of the money to leave the system. But it is in no position to raise interest rates significantly because of the weak state of the economy. If anything, the Bank of Japan will be under some pressure to print new money to lend to the banking system. That will help the banks fund the government's deficit by buying more government bonds.

To summarize: the technology story in Japan looks interesting, the liquidity environment is promising, and individuals are dramatically underexposed to equities. The rally in Japan's market in 1999 looks to us like the beginning of a multi-year bull market. The caveat for foreign investors is that the yen could weaken as Japan struggles with the painful adjustments needed to restructure its financial system and old-line industries.

We currently have nearly 15% of our global equity portfolios invested in Japan, with a distinct tilt toward companies that are poised to benefit from the technology and telecommunications revolution. But in view of the potential for further weakness of the yen against the Canadian dollar, we have hedged a significant portion of our yen exposure.

Japan's overall economy may remain rather anemic for some time to come - as was the case in the United States after its banking woes in the early 1990s. But if Japanese companies successfully make the transition to the digital era, Japan's stock market will be hard to ignore.