Markets dislike ambiguity and the current BOJ/government standoff has only exacerbated investor despair and frustration which has resulted in further selling by foreigners in search of supposed better pickings elsewhere in the region. Ongoing confusion over the scale of potential fund raising requirements in the banking sector coupled with a wave of secondary equity issues are but two further reasons to encourage further selling. In many respects the only surprise is that the market has not fallen further given the indiscriminate selling that usually accompanies foreigners exiting from Japan. We however see various reasons to be more optimistic over the coming months as the BOJ ultimately ease tight monetary policy after reviewing firm government budget proposals for next fiscal year and thereby reassuring themselves that the new government will not send JGB yields sharply higher on the strength of undisciplined budgetary approach. Recent press articles suggesting that the DPJ will have to water down main election promises such as child allowances point to a more detailed and realistic understanding of the precarious state of government revenues. The major unknown is the extent to which the government will initiate wider reform that will ultimately involve significant deregulation and result in industry consolidation and therefore we do not expect investors to be brave and pre-empt such an outcome.

The root of our optimism lies in developments within the corporate sector and valuations that are becoming attractive. More proactive corporate managements are embarking on interesting M&A strategies, be it Family Mart, Canon, Sundrug to name but three transactions announced this month, and we expect this trend to continue as companies appreciate the need to ignore the current domestic problems and build out longer term strategies. The ongoing yen appreciation will, we suspect, only further focus corporate minds towards more deep rooted restructuring as they shortly sit down to discuss budgets for the next financial year. Although we detect that labour concerns are delaying certain restructurings, the proposed 40% pension reductions at JAL are a pertinent reminder of how years of postponing the ugly day can have unpleasant and radical outcomes. Of greater near term significance is the banking sector and their reluctance to sell cross shareholdings to the BOJ which, if implemented, would significantly reduce risk weighted assets, capital raising requirements and wider secondary equity issuance which is the result of banks reluctance to increase company specific loan exposures. This issue will be one of the main areas of focus in our forthcoming visit to Japan. On the valuation front, we are encouraged by examples of 14% free cashflow yields at certain companies although we recognise that the market will not reward such companies until a generally more optimistic tone develops but it is worth reiterating that valuations, whether they be PER/PBR/PCF, for many more domestic stocks are now lower than at the time of the overall market low in March. As regards the more international blue chip companies, perhaps the ongoing yen appreciation will result in weaker shareprices yielding entry points for global investors on compelling valuation grounds.

The next few months will determine whether the Japan has the nerve to implement significant change to generate sustainable nominal GDP growth over the longer term or continue to resort to stop-gap policy that will ultimately lead to further domestic economic contraction and the further de-rating of the domestic equity market. With foreign investors the only possible buyers at the margin, the stakes are getting sharply higher.

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