Research & Investment Strategy Weekly Comments 547 15th June 2011

Japan: V-shaped rebound confirmed

Key points
Sharp recovery in the pipeline, due to inventory replenishing and private consumption. Growing threat of power shortages during the summer. Taxes will probably be raised in 2012 and 2013. The Japanese market seems to have discounted a lot of negative news but is not outright cheap. Start moving back into the marketat least if you are an investor who does not follow a benchmark. Three months after the terrible earthquake of March 11, which ravaged North-eastern Japan, the country is just now starting to bandage its wounds. A V-shaped recovery in the coming months is not doubtful in the least, but the consequences of the catastrophe, both on the political and economic fronts, are giving rise to fears of a delay over the summer.

All economic indicators confirm that the trough was reached in April and that the recovery began in May. The improvement is quite palpable in the manufacturing sector, with a PMI reading that moved once again above 50 points in May. The forecasts from the Minister of Industry give reason to hope that the rebound will extend into June at least, with high monthly growth rates (8% in May and 7.7% in June). Still on the supply side, services rebounded in April, correcting for 40% of the decline observed between February and March. In the short term, the economic rebound is obviously being driven by the recovery in production for the sectors that suffered the most from the earthquake. The replenishing of inventories will also play a critical role because the latter, already substantially diminished during the financial crisis, had not yet been fully restored before the earthquake. On the demand side, the decline in business activity levels led to substantial job losses (-600,000) between February and April. A plunge of this magnitude in employment over two months had not been seen in Japan since the first oil crisis of 1974. Initially, the bad news on jobs focused all of the fears of Japanese households, but the real threat to the morale of the Japanese consumer is actually more in terms of income growth over the medium to long term. Indeed, the earthquake weighed adversely on corporate earnings and, in this context, it is difficult to anticipate higher bonuses for wage earners in the months ahead. This being said, the contraction in payroll, related to a one-off shock, should only be transitory. The economic recovery will be accompanied by a rise in employment and this will in turn provide more solid support for consumption. We can also expect to see an uptick in private consumption in the run-up to the possible, if not probable, VAT hike in 2013 and the impact on income in 2012. We will revisit what was until recently a taboo subject; but there is a very good chance of seeing a repeat of the scenario observed in late 1996early 1997. At the time, the Hashimoto governments decision to raise the VAT from 3% to 5% led to a sharp rise in private consumption just prior to the actual hike, followed by a deep depression in the two quarters that followed. Therefore, it seems to us that consumer spending will remain hesitant in Q2 but will thereafter become a driver of growth, particularly at the end of this year and into the

A deep and destabilising though temporary shock

Japans national accounts for Q1 cast a stark light on the economic impact of the earthquake. Quarterly GDP fell by 0.9% even as a rapid recovery was shaping up in January and February. It comes as no surprise that inventories are way down and household consumption has ground to a halt.
The Japanese recovery is gathering pace
60 6 4 55 2 50 0 -2 45 -4 40 -6
%yoy

35

Manufacturing PMI index GDP [RHS]

-8 -10

30 2004

-12 2005 2006 2007 2008 2009 2010 2011

Source: ESRI, Datastream, Bloomb erg, AXA IM

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Japan: V-shaped rebound is confirmed 15th June 2011

beginning of next. Vehicle registrations in April and May were in line with this scenario, revealing a certain waitand-see attitude despite the recovery underway.

rate hike is an increasingly likely scenario under the circumstances. This second stimulus plan will be decisive in determining the speedy return of Japans GDP to growth, though the instability at the head of the executive branch could slow down the process. The main question at this point concerns early elections if PM Naoto Kan were to resign before a vote is taken on the plan, at a time when his party is more divided than ever. Although hypothetical, this scenario is weighing adversely on investors morale.

Risk of power shortages this summer rising steadily

The summer, which corresponds to peak demand for electricity, is increasingly a cause for alarm. The consequences of the earthquake are being felt not only in the regions devastated by the disaster, but throughout the country. Many businesses have in fact moved their production westward, and this has led to durably higher than normal demand for power. At the same time, the nuclear power plants that have been shut down for maintenance have not yet reopened. In mid-June, 37 reactors out of 54 (which is 14% of total electrical power production capacity) were shut down, with four additional reactors possibly joining them in early July. So the risk of shortages is real, and not just in and around Tokyo. In early April, we estimated the elasticity of GDP to electricity production to be around 0.2, and we concluded then that this would shave anywhere from 0.2 to 0.4 percentage points off GDP growth in Q3, based on inadequate production just for TEPCO. Taking into account the nuclear power plant closures across the country, the impact could be as high as 0.6 percentage points in the worst case.

Appealingly priced equities? Not so fast!

Surprisingly, international investors kept buying the Japanese stock market at least until very recently, whilst domestic investors moved to the sidelines as earnings expectations of the Kabuto-cho tumbled. We think that this movement is not over yet. Earnings will most likely remain depressed until i) the full impact of the past recession has been digested, ii) the currency starts to weaken significantly, and iii) the Asian recovery shows signs of traction. Yet a big chunk of negative earnings seems to be priced in. Different classic valuation measures suggest that the market offers value for the long-term investor. Currently, Japan trades at 5.7x price/cash flow compared to 8.9x for the entire MSCI universe. However, on a more forward-looking metric such as the PEG ratio, the Land of the Rising Sun trades almost at par with global markets (1 standard deviation below its average). This clearly shows the degree to which investors doubt current earnings and earnings projections. We also know, however, that Japanese earnings are more a function of volume than anything else. If production recovers, earnings should find a solid underpinning and thus offer a decent floor to current valuation. We therefore suggest increasing the weighting of the Japanese market in the months to come, at least for those investors who are not tied to a benchmark.

The risk of a debt spiral is pushing the government to think about higher taxes
Beyond the risk of power shortages, the magnitude and the workings of the government reconstruction program for the devastated regions will also have an impact on the recovery. The first budget add-on was adopted in May, equal to 0.9% of GDP. This plan will be totally financed through the reallocation or the reduction of expenditures already programmed, to avoid the risk of a new deterioration in the countrys sovereign debt. The principal rating agencies have clearly warned the government against debt-financing the reconstruction effort. So there should not be any additional demand, and stimulation of the economy will be based solely on the multiplier effect of expenditures. A second stimulus plan, the magnitude of which could be between 2% and 3% of GDP, is currently being worked out and could be adopted sometime in August. It now seems to be a foregone conclusion that this second plan will be financed via the issue of reconstruction bonds, which would be distinct from traditional bonds for construction and for financing the deficit. One of the specific features of these reconstruction bonds lies in their repayment structure, which would come through dedicated tax revenue. A report will be submitted to the government on this subject at the end of June. A VAT

Conclusions
A V-shaped recovery is likely, but the bottleneck caused by electricity production woes and political uncertainties could disrupt the rebound, at least temporarily, over the summer. We think that GDP will shrink in 2011 by 0.3%, followed by a rebound of 3% in 2012. Longer term, the inevitable rise in tax pressures will weigh, at least initially, on the outlook for growth, especially as the countrys potential growth converges more and more toward zero.

Herv LIEVORE & Franz WENZEL

Research & Investment Strategy AXA Investment Managers _____________________________________________ The written material contained herein was completed on June 14 2011 2

Japan: V-shaped rebound is confirmed 15th June 2011

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Research & Investment Strategy AXA Investment Managers _____________________________________________ The written material contained herein was completed on June 14 2011 3