Foreign Investors Push for Better TSE, OSE Merger Terms

Large foreign holders of Osaka Securities Exchange (8697.T. OSE) are unhappy with the complicated terms of the proposed merger between the Tokyo Stock Exchange (TSE) and the OSE. The exchanges announced a merger agreement on November 22 last year, with the TSE agreeing to pay JPY480,000 a share for the OSE. OSE shares have been trading at a slight discount since, however, ostensibly because of the face-saving (for both sides) terms of the deal, where the TSE first makes OSE a subsidiary by acquiring a maximum of 66.6% of oustanding shares, then effecting a reverse merger through a stock swap that ostensibly makes the OSE the surviving company, at a ratio that values the TSE at 1.7 times the OSE.

The OSE has one of the highest foreign ownership ratios in Japan at 63% (as of September 2011), and they are unhappy with the announced merger terms, insisting the merger ratio should be closer to 1:1 because the OSE ranks nearly even with the TSE in terms of profitability. They believe the TSE should be paying something more like JPY550,000 per share for the OSE. Big holders of OSE stock like Fidelity (14.1%) and JO Hambro Capital Management (5.1%) may vote against the proposed merger, which requires a two-thirds majority approval from shareholders.

Seeing as how the deal has already almost fell through several times before the convoluted terms were agreed upon, it is unlikely that the terms will be changed unless the shareholder resolution to approve the deal does not pass, which is possible if the bulk of the OSE's foreign holders vote against the proposal. 

If the deal collapses, however, investors would find themselves holding a lot of illiquid OSE stock that would undoubtedly see a tumble.  Globally, since nearly all attempted cross-border mergers of exchanges since last spring have failed, such as the proposed merger between NYSE Euronext and the Deutshe Boerse. Even if there were a favorable global environment for exchange mergers, the TSE may be the only realistic suitor for the OSE. 

(Source: Nikkei Net)

Nikkei 225 Still in Breakout Mode

The Nikkei 225 took a tumble of over 230 points and slipped below the 10,000 watermark again on Tuesday, as a weak March Tankan, the Fed dismissing any Q3 talk and questionable China PMI data threw cold water on the budding enthusiasm for Japanese stocks, which were the top performers in Q1 2012. 

JPY is slipping away from the JPY83/USD recent weak point, as JPY weakness is predicated on a) a widening US-Japan bond yield gap, in turn which is predicated on b) continued BOJ balance sheet utilization and c) continued favorable US economic news. 

However, the Nikkei 225 has only just broken up out of a downtrend phase in place since the 2007 high, unlike the S&P 500 rally which is looking increasingly long in the tooth. Investors would have more confidence in the bullish Japan story they have concocted if there were more evidence that the budding recovery is gaining traction and there is more evidence that Japanese corporate profits can rebound at the 30%~40% YoY in FY2012 that many are projecting/expecting--thereby giving Japanese stocks enough juice to delink from any interim selloff in US stocks.

Source: Yahoo.com

UBS Japan Defections

Bloomberg is reporting that five of UBS AG's Tokyo analysts, including their chief stock strategist as well as their electronic parts, media, insurance and energy analysts have left the firm's second-ranked (according to Nikkei Veritas magazine) Japan research team, seeking greener pastures, ostensibly after UBS Chief Executive Officer Sergio Ermotti said last November he plans to cut 2,000 jobs in the firm's investment banking arm by 2016 to reduce risk and boost profit after the firm took a $2.3 billion hit from unauthorized trading.

Bloomberg

Japan's Latest Austerity Trap: Not

In an article titled "Japan's Latest Austerity Trap", the Wall Street Journal disses the Noda Administration's efforts to raise the consumption tax without offering any specific (and realistic) suggestions as to what Japan could do in lieu of not raising consumption taxes. The WSJ's view is that consumption tax hikes and other austerity measures will only push Japan down the path of Greece, i.e., push Japan's economy into a Dutch roll. Japan is already uncompetitive with their South Korean and Chinese counterparts ostensibly because of higher taxes and restrictive labor laws. The WSJ's simplistic solution; a) Cut back on future entitlements, and b) Faster economic growth, which can only happen if taxes are cut, not raised. No suggestions however were given regarding just how Japan is supposed to achieve this faster growth.

After hundreds of trillions of yen in "failed" Keynesian stimulus that have not restored sustainable growth to Japan but has left a legacy of government debt over 200% GDP, Ostensibly only super-low interest rates ostensibly stand between Japan and a major fiscal crisis. But the flip side of this debt is an equally large financial surplus in the private sector, as nearly all of this debt is owed to the domestic private sector, a much smaller amount of which is JGBs directly owned by individuals, and a miniscule amount of which is owned by foreigners.

The WSJ insists that even a doubling of the consumption tax won't be enough to plug government deficits by 2020 given current spending trends. The view is that the Noda Administration is being "irresponsible" by toeing the DPJ (Democratic Party of Japan) line by recommending new welfare measures to help the poor and sticking with its promise to offer stipends for taxpayers with young children. And they are right on this point, as a mix of fiscal policies and monetary policy is needed, from ample monetary policy support from the BOJ (bank of Japan) to entitlement reductions. Spending on social security benefits in Japan has risen by almost 60% over the past 15 years, largely due to rapid population aging, making "social security entitlements" Japan's biggest outlay, in the formally approved annual budget, at least. 

Otherwise, the WSJ article is long on opinion and short on facts.  Rather than consumption tax hikes pushing Japan down the path of Greece, nearly all mainstream economists within and without Japan, the OECD, the IMF and other institutions see Japan as having ample room to raise these taxes vis-a-vis their OECD peers. Japan's current VAT of 5% is among the lowest in the world, and even a VAT of 15% is still modest by OECD standards, as VAT in Euroland averages 20%, with VAT in the Nordic states more like 25%. Overall tax revenue to GDP at 17% is among the lowest in the OECD, while corporate taxes at 40% are relatively high. A 10% GDP adjustment is possible through mix of fiscal revenue generating/spending cutbacks combined with continued ample monetary stimulus. 

The push for the VAT hike is not "irresponsible" in that, a) its relatively cheap and easy to administer, b) its less subject to business cycle fluctuations than income taxes, c) probably has less detrimental impact on growth, d) is likely to be more robust in a graying nation, and e) last but not least, it is essentially the only source of revenues (excluding perhaps land/asset taxes) that on paper could provide the needed scale of revenues. "Wasteful" public works spending has already been slashed by two-thirds in the last decade and health care expenditures are already lean by OECD standards—at 8.5% of GD. If Japan really wanted to be bold, it could raise the consumption tax to 25%, raise the retirement age to 70 and institute a land tax to cut a big swath in its out-of-control government debt.  

A VAT hike would lower growth by some 0.3 percentage points per year on average during the first three years, compared to the case with no fiscal adjustment, but eventually the impact on the level of GDP turns positive as the government turns the tide of public debt and improved confidence reduces precautionary saving and boosts spending. Further, it would take the looming fiscal train wreck risk off the table, which is already threatens to stop any growth Japan has in its tracks with a fiscal crisis and a significant back-up in bond yields.

Tripling Japan's VAT rate to 15% in Japan would be regressive in that it would increase the tax burden for households in the bottom 20% percent of the income distribution by 9% of their current income, compared to only 4½% of current income for those in the top 20%, but this is less adverse impact than from higher personal income and corporate taxes.

A nascent economic recovery is at last underway in Japan. With observers and most politicians being unsure of its sustainability, and fear that Nagata-cho's new found eagerness to raise consumption taxes will, as was the case during the Hashimoto administration, kill off the budding recovery and stifle the very consumption recovery Japan needs to grow again. But Japan can no longer afford to ignore "the debt problem". After delaying action for the last decade hoping for a sustainable recovery, Japan's politicians need to realize there will be no sustainable recovery without the hard decisions and action needed to address the debt that is choking off growth. 

Sure, anyone living in Japan is basically against a VAT increase, because they (we) have become very cynical about Nagata-cho politicians pissing away taxpayer money, and want to see a good, honest effort to get "wasteful" government spending under control. What many do not fully realize is that much of this spending is going to their entitlement programs. If you want to see some real wailing and gnashing of teeth, just wait until the government attempts to reign in entitlements. What any administration is afraid to admit to their constituents is that the government is broke, and that any attempt to dig out of the debt hole will be a drawn-out, painful process.

As for the WSJ's comment that Japan is already uncompetitive with their South Korean and Chinese counterparts ostensibly because of higher taxes and restrictive labor laws, you'd be surprised how much Japan's "competitiveness" could improve given a 30%~40% re-alignment of JPY against the Won and other Asian currencies. 

Wall Street Journal

Sumitomo Realty's Big Bet on Tokyo Commercial Real Estate

Sumitomo Realty & Development (8830.T) is embarking on a bullish JPY20 billion bet demand in central Tokyo for disaster-ready office space will be strong over the next five to six years, with five major projects in central Tokyo with floor space in the range of 100,000 to 200,000 square meters. Quake-resistant buildings already account for about 60% of all Sumitomo Realty's properties.

Construction on the first project in the Nihonbashi district will begin this summer with a 35-story tower complex due for completion as early as FY2014. The tower will feature earthquake-damping equipment and a hall that doubles as a disaster shelter for stranded workers. A project for offices and residential buildings in the Roppongi entertainment district will begin as soon as this fall, with completion scheduled for FY2015, in the area once the Japan HQ of IBM Japan Ltd. Other projects are on the table for buildings in Osaki, Takadanobaba and Mita for FY2013 and beyond. In total these projects will create some 900,000 square meters of new floor space

In Roppongi, work on a block of office and residential buildings will begin as soon as fall. Sumitomo Realty aims to complete this project in fiscal 2015. The area was once home to the headquarters of IBM Japan Ltd. The developer is also planning to start projects in Osaki, Takadanobaba and Mita in fiscal 2013 and beyond.

This despite stubbornly high central Tokyo office vacancies that is creating fierce competition for tenants. Miki Shoji reckons the office vacancy rate at the end of February was 9.15% and is expected to worsen with the new buildings set to open this year.  Sumitomo Realty's bet of course is that good, centrally located office space will remain attractive over the longer term. New buildings with entire floors available to a single tenant are still popular with companies looking for more efficient workspace. Since the March 11 Tohoku disaster, corporate tenants are also looking for buildings with better earthquake countermeasures. 

Sumitomo Realty's stock has already surged over 50% this year on an improved outlook for Tokyo property, and as investor money returns to Japan real estate on the view it is now undervalued vis-a-vis other countries in Asia.  The stock could see some short-term consolidation given the sharp gains YTD.

Conflicting China PMIs and a Mediocre Tankan

The Chinese PMI (purchasing managers index) released yesterday by the country’s logistics federation and National Bureau of Statistics for March rose to a one-year high of 53.1, in direct contrast to the PMI from HSBC Holdings Plc and Markit Economics showing manufacturing contracting and export orders declining. The HSBC index fell to 48.3 in March from 49.6 the previous month. The figures contrast with the with good gain in the ISM’s U.S. factory index to 53.4 from 52.4 in February. Economists forecast an increase to 53.

The yen strengthened even after the quarterly BOJ Tankan index of business sentiment for Japan’s largest manufacturers was unchanged last quarter from minus 4 in December. That was less than the median estimate of minus 1 in a Bloomberg News survey of economists, and indicates that Japanese business sentiment hasn't improved despite the weaker yen, growing rebuilding momentum in the Tohoku region, and an improvement in exports to North America.  The forward index for the June Tankan was seen at minus 3 for big manufacturers and plus 5 for big non-manufacturers. As far as Japanese manufacturers are concerned, while the economy in the U.S. is solid, China is clearly slowing and import demand is waning, while they are still worried about demand in Europe given the high unemployment and recessionary forces. 

The weak Tankan was however of little surprise to domestic investors, whose reaction to the "surprise" Tankan reading was muted. The slight weakness in stocks the day after appears to be more due to USD weakening to the upper JPY81 range, extending its overnight losses on a fall in U.S. Treasury yields.

The continued weak business sentiment has increased investor expectations for further BOJ action, and the BOJ is expected to increase its asset purchase program by JPY5 trillion ($61 billion) solely through government bond purchases, according to some domestic economists. Further easing which would provide further impetus for Japanese stock prices, as foreign investors have reacted positively to BOJ easing measures last November as well as in February. 

A recent Reuters poll shows investors expect Japan's economy to grow around 1.9% in FY2012 beginning this month as exports recover from the middle of this year, mainly on signs that the U.S. economy is regaining strength. The boost from the U.S. recovery however could be offset by a weaker-than-expected China economy, and the drag from slower import demand from China will keep growth of the widely expected Japanese economic recovery lower than a very resilient U.S. economic recovery.

Nikkei 225 Outperforms in Q1 2012

The Nikkei Stock Average ended fiscal 2011 at 10,083.56, up 328.46 points, or 3.4%, from its level at the end of fiscal 2010. Year-to-date, the Nikkei is now up 19%--its best showing for the January-March period since 1988, as is one of the best-performing global equity markets during the quarter. Foreign investors accounted for around 65% of trading in Japanese stocks in fiscal 2011, with their share of all transactions reaching a record high for the second year in a row. Foreign investors have been the single largest block of shareholders of Japanese equity since 2004, meaning that, as foreign buying/selling goes, so goes the Nikkei 225, Topix and other major benchmark Japanese equity indices.  

Nikkei 225 versus Foreign Buying

On the other hand, the major benchmark indices are now less responsive to bouts on the upside to net foreign buying. The reason is the steady unwinding of cross- and strategically-held shares by Japanese corporates, insurance companies and banks, that at times overwhelms even the net buying of foreign investors. We see no significant change in the structural net selling of domestic institutions for the foreseeable future. As shareholdings by life/non-life insurers and money center as well as regional banks have declined to 4.5%, 4.1% and 1.9% of total listed outstanding shares respectively, their influence on Japanese stock prices has all but disappeared. On the other hand, non-financial corporations and trust banks (traditional managers of the nation's pension funds) continue to hold 21.9% and 16.2% of outstanding listed shares, and represent the biggest structural drag on Japanese equities.

Ownership of Japanese Shares

The biggest catalysts for foreign buying of Japanese equities have been a) expectations that reconstruction demand in the Tohoku region will support a temporary growth acceleration in Japan's GDP in 2012 and 2013, b) a major directional turn in JPY's real effective exchange rate and c) global economic recovery, to which Japan's economy is highly, cyclically correlated to. The Nikkei 225 and Topix currently appear to be discounting a 30%~40% aggregate profit rebound in FY2012, boosted by continued JPY weakness. 

The March Bank of America Merrill Lynch survey of global fund managers shows a net 28% (versus 11% in February) expect the world economy to strengthen in the next 12 months, despite Euro sovereign debt, China slowdown and high crude oil concerns. These investors are also more optimistic about corporate profits. Confidence in the U.S. economy in particular has risen. Conversely, while confidence in the Chinese economy has deteriorated, Japanese fund managers are the most bullish about Japan's economy, with a net 91% saying Japan's economy will get stronger, versus only 47% two months ago. The OECD also says the global economic outlook is improving, and even expect that Europe will pull out of recession over the next three months, with only Italy being in recession by June. While the OECD also sees recent signs of slowing in several emerging economies, it is confident that governments of emerging nations have the ability to stimulate their economies with lower rates and budget spending. 

Consequently, the technical/quantitative picture for the MSCI Japan ETF (EWJ) are now very positive, while the technicals for individual Japan ADRs are most positive for Hitachi, Toyota and Canon. On the other hand, the chart technicals for NTT as well as NTT Docomo indicate that these ADRs in addition to Wacoal, Kubota and Makita should be avoided for the time being.

Technicals Most Positive for Hitachi, Toyota and Canon

Japanese Bankers Association: Japan Must Overhaul Taxes to Avoid Bond Market Rout

Japanese banks, the biggest holders of JGBs (Japanese Government Bonds) are now officially concerned about the looming train wreck in Japan's public finances. Japan needs to quickly overhaul the tax system to prevent government borrowing costs from spiraling in the next decade, says the new head of the Japan Bankers' Association.

The BOJ's Masaaki Shirakawa warned in February that the Country's banks risk incurring trillions of yen in losses if yields rise,Mizuho Financial Group president Sato also warned last month that any delays to the "reform that is being debated" (i.e., consumption tax hikes) may raise concern that new bond issues may not be absorbed domestically in the "long run", say, in 2022, or 10 years from now.

Currently, there is no evidence of the impending train wreck in JGB yields, which were at 0.985% at the end of the FY2011 fiscal year (March 30). CMA data also show 5-year CDS (credit default swaps) are down to 98.6bps from a record 154.8 on October 4, implying investors are becoming more, not less sanguine about Japanese government credit default risk, ostensibly because the Noda government is trying to push through a big consumption tax hike bill.

The BOJ said in February that a 1 percentage point increase in benchmark yields would cause losses of som JPY3.5 trillion on major bank holdings of JGBs, who held a record JPY167.8 trillion in JGBs as of February 2012.  Meanwhile, the three major banks, Mitsubishi UFJ FG (8306.T), Sumitomo Mitsui FG (8316.T) and Mizuho FG (8411.T) made a tidy profit of JPY231 billion (up almost 2X YoY) from trading bonds in the quarter ended December 2011.

The Noda Administration is finding the going for approval of his tax bill in the current Diet session a hard slog, with politicians in his own party opposing, as well as the LDP, who insists that elections should be called first. The Noda Cabinet did approval a proposal to raise the consumption tax to 8% in April 2014, and to 10% by October 2015, from a current 5%.  The Bankers' Association has apparently jumped into the fray, trying to push the legislation through the ongoing Diet gridlock.

Bloomberg