International mutual fund managers have poured billions of dollars into the Japanese stock market recently, a strategy that has not paid off so far and has more than a few analysts worried.
“There are some significant risks with respect to Japan right now that investors should be aware of, especially with regard to the country’s banking sector,” said Jack Bowers, editor of Fidelity Monitor, a newsletter that monitors the performance of mutual funds managed by industry behemoth Fidelity Investments.
The risks in Japan center on a fragile economic recovery that could be jeopordized by severe problems in the country’s banking system. The problems in the financial sector are especially worrisome because grass-roots opposition to a government bailout of the banks is proving much stronger than anticipated.
“Mutual fund managers are betting on the Japanese market’s cheap valuations,” says Alexander Kinmont, London-based Japanese equities strategist at Morgan Stanley & Co. “Recent developments have made a bullish position harder to hold.”
In March, the government appeared to have wrapped up passage of a bank bailout package, which economists deem essential to help build confidence and get the economy rolling again. The bill, however, has gotten stymied by strong political opposition, including high-profile, round-the-clock sit-ins by oppposition parliamentarians.
No one knows when the government will find the courage to tackle the critical bank bailout issue again.
U.S. investors have had a strong thirst for international equity funds this year, and much of the money that investors poured into international funds has been invested by portfolio managers into Japanese stocks.
Two of Fidelity’s international funds, International Value and International Growth and Income, had as of mid-March 66.3 percent and 49.4 percent, respectively, invested in Japanese equities. “These types of heavy weightings may be inappropriate,” says Bowers.
In January, 17 percent of the $33 billion Americans spent on equity mutual funds went to the international sector. During that same month, foreigners bought a near-record $8.79 billion worth of Japanese stocks. Foreigners, many of them U.S. mutual funds, now own a record 10 percent of all Japanese equities.
According to AMG Data Services, investors pumped money into Japan funds at the rate of $40 million a week in January.
“In due course, Japan’s financial problems will be solved, but in the meantime the risk factor in the Japanese stock market is going to be higher,” says Kinmont.
After surging late last year, Japanese stocks have floundered this year, in part as a result of the turmoil in the banking system. A list of international funds with large exposures to Japan, supplied by Morningstar, shows paltry returns for this year ranging from about 2.5 percent on the high end to minus 1 percent on the low end. Funds investing exclusively in Japanese stocks show strongly negative returns of between minus 7 and minus 1 percent.
Japan is going through what is very roughly equivalent to our savings and loan scandal in the 1980s.
Based on a flood of dollars from surging exports to the U.S., a lax monetary policy and even laxer government oversight, prices of assets exploded in Japan during the 1980s. Everything from real estate to stock prices went through the roof.
When the Bank of Japan finally starting raising interest rates in the late 1980s, that action pricked the asset bubble. Real estate, stock and other asset values fell to earth. The problem, as always, was that banks had lent money based on those inflated values and were left with about $400 billion of worthless loans on their books, especially in real estate.
What many have been calling for is a solution along the lines of a Resolution Trust Corp., which is the special purpose corporation created by Congress to deal with the S&L mess. The RTC is winding down its operations now, having saddled the U.S. taxpayer with a bill for the S&L fiasco of well in excess of a half-trillion dollars.
Most U.S. taxpayers were pretty exasperated with such an outlandish cost of the bailout, and were plenty mad at bankers and Congress alike. But they didn’t pour into the streets and protest in the tens of thousands.
“Banks are very unwilling to make new loans without a resolution to this thing,” says Bowers. “Without new loans, there’s no economic growth.”
Despite reducing interest rates to practically zero, the Japanese economy has been in a virtual depression, especially with regard to asset values. “It’s like Wal-Mart, you have to watch out for falling prices,” says one analyst.
The performance of Japanese government bonds, known as JGBs, has been superlative relative to the stock market in recent years. But Gerard MacDonell, managing editor of the Bank Credit Analyst’s Interest Rate Forecast, says that’s about to change.
“The Japanese bond rally is over and investors can expect a marked rise in JGB yields this year,” says MacDonell.
It is these types of predictions that have fueled the big interest by mutual fund managers and other international investors in Japanese stocks. Many people, including Kinmont, have predicted that rising Japanese bond yields, and falling Japanese bond prices, would lead to a wave of domestic Japanese bond sales.
Analysts have been predicting that Japanese institutions would take the money from the bond market and pour it into the stock market, the first such buying spree in years.
But the problem with that scenario is that Japanese investors live in Japan, and they watch the news every night. On the news, night after night, is intense coverage of physical fights and sit-ins in the Japanese Diet over the bank bailout. Add to that thousands of protesters, and you get a mix that doesn’t encourage stock buying.
The reason why the Japanese aren’t buying their own stocks is uncertainty and high levels of risk stemming from that uncertainty. If you don’t have a stomach for uncertainty or risk, you might want to check your international mutual fund for Japanese holdings.
If the holding is anywhere near 40 percent or higher, consider making adjustments to your own mutual fund portfolio, at least until things become a little clearer in Japan.
