MCLEAN, Va.–Shinzo Abe was elected Prime Minister of Japan on September 26; I had provided a brief background on Abe as his term as Junichiro Koizumi’s Chief Cabinet Secretary neared its end (see SRI, 16 August 2006, A Political Summer). The new administration has begun to reveal its goals, and it’s time to take a closer look at developments in Japan.

Abe has taken immediate action to articulate a market-friendly and pro-change message. Investors should bear in mind that although economic change remains a priority in Japan, international relations and, consequently, domestic politics will play a major role in determining Abe’s success. And Abe’s Liberal Democratic Party (LDP) will have to perform well in the upcoming July 2007 Upper House elections (although not a general election, the outcome will influence government action). Such an election is always an extra burden for a new leader.

Abe has been quick to visit China and South Korea, driven by the demands of electoral politics. Traveling to China first was also a good public relations move, as it emphasized that Japan views China as an important neighbor worthy of the “first visit,” though it’s common knowledge that the US is Japan’s main international ally.

Establishing smoother relationships with its neighbors will undoubtedly give Abe more leverage domestically, and will therefore allow him to more easily implement economic changes.

Keep in mind that Abe gained national prominence in 2002 by pressuring North Korea into allowing five kidnapped Japanese citizens to return home for a brief visit. He became a political star when he then successfully argued that Japan shouldn’t allow the victims to be returned to North Korea as planned. His credentials as a nationalist are strong–so the opposition can’t touch him–and Japanese have felt comfortable with him from the start of his term. In this context, Abe will be able to advance his economic agenda, an extremely positive development for long-term Japanese equity market returns.

North Korea’s latest actions have provided Abe an opportunity to demonstrate toughness and to generate a consensus among neighbors in case Japan decides to impose sanctions of its own on the rogue regime. And closer economic ties among Japan, South Korea and China would also stimulate Asian economic growth.

Another aspect of the Abe transition concerns the new Prime Minister’s administrative appointments. There are two main entities at issue, the cabinet and the Council on Economic and Fiscal Policy (CEFP). The CEFP is extremely important to investors as it’s the main economic policy making body for Japan. It’s headed by the Prime Minister and includes the Chief Cabinet Secretary, the Minister of State for Economic and Fiscal Policy, the Minister for Internal Affairs and Communications, the Minister of Finance, the Minister of Economy, Trade and Industry, the Governor of the Bank of Japan and four private-sector experts.

The appointments of the four private-sector experts are critical when it comes to the direction as well as the credibility of the CEFP because they represent the dynamic, market-friendly section of the council. And Abe’s appointees–including Fujio Mitarai, former Chairman and CEO of Canon and current Chairman of Nippon Keidanren, Japan’s most important business organization, and Uichiro Niwa, a restructuring expert and Chairman of Itochu Corp, one of the biggest trading (imports/exports) companies in Japan–are top-of-the-line. Economists Taketoshi Ito of Tokyo University (he’s done a lot of work on deregulation and has taught at the University of Wisconsin-Madison and Harvard University) and Naohiro Yashiro of International Christian University, the former president of the Japan Center for Economic research, a premier economic think tank, and also a deregulation and medical systems economics expert, round out the CEFP.

The CEFP presented the following economic policy goals last week: increasing productivity through innovation; making the labor market more efficient; building an economy open to the world–and in particular Asia; deregulating the agricultural market to expand the domains in which private-sector firms can participate; creating market-based medical and nursing-care systems; shifting to more efficient uses of assets; and granting more autonomy to local governments

As far as the economy is concerned, I’ve made the case for Japan’s long-term potential on numerous occasions. The main idea is that the current economic cycle in Japan will be stronger and more enduring than most market observers anticipate. This view is based on the structural changes taking place in the Japanese economy (including changes in government financial institutions), the end of deflation and the fact that, as many years of depression come to an end, Japanese are now much more optimistic about the future than they’ve been for a long time.

An encouraging factor is the return of domestic demand. Employment has been picking up and real wage growth has been accelerating. The latter is important because it allows consumers to eventually use some of the money that’s been sitting in bank accounts for investment and consumption.


Source: Bloomberg

The increased participation by local investors (retail and institutional) in the Japanese markets should gain traction as the Japanese economy steadily improves and risk tolerance rises. More than $250 billion is expected to come into the market in the next five years–9 percent of the Nikkei 225’s total capitalization. Looking at the high percentage of their assets that Japanese households allocate to deposits accounts, the above target looks quite feasible, especially as an increasing number of vehicles for investing in the markets are made available to Japanese investors.



Source: Bank of Japan

Japan, as I’ve previously noted, is in a secular bull market that commenced in 2003 when the TOPIX Index was trading at around 800. (I refer to the TOPIX Index, the capitalization-weighted index of all companies listed on the First Section of the Tokyo Stock Exchange, because it offers a more comprehensive picture of the Japanese market.)

Although the Japanese market hasn’t performed well this year, I still recommend exposure to it and I’ll be adding more Japanese companies to the SRI Portfolios.

That Japanese banks and financial companies will benefit substantially from the changes taking place in Japan is a perennial SRI investing theme. Therefore, I’m adding Mitsubishi UFJ Financial Group (NYSE: MTU) to the SRI Portfolio and Sumitomo Mitsui Financial Group (OTC: SMFJY) to the Alternative Holding Portfolio. Sumitomo has lagged the market, but it could play catch-up once the Japanese market enters a stronger performance period.


Source: Bloomberg

Turning to the markets, I remain fairly optimistic. I recognize and appreciate the bearish case, but markets can continue to perform much better for longer than many investors expect (absent a major geopolitical incident).

As I noted in August (see SRI, 23 August 2006, Fall Rally?):

It’s possible that markets are underestimating the slowdown in the US economy, but it’s impossible to define with certainty those factors the markets have discounted and those they haven’t. It’s therefore extremely difficult to quantify any impact. At this juncture, I recommend constraint but not bearishness because the market can rally from here.

Inflation remains a concern for many investors, pundits and policy makers. I’ve presented my views on the subject (see SRI, 17 May 2006, Debating) and my assessment is still that inflation doesn’t seem to be such a threat–at least for now.

The following chart is the Economic Cycle Research Institute’s (ECRI) future inflation gauge for the US. It continues to roll over, indicating that inflation may prove to be less of a threat to the markets than is commonly believed.


Source: Bloomberg

Asia, Japan, “Old” Europe and Russia are still my favorite markets, as you can easily deduce based on the composition of the SRI Portfolios. The SRI Portfolio remains concentrated in domestic-oriented companies (when it comes to Asian/Japan holdings), while most of the remaining recommendations should benefit from global economic change (see SRI, 15 February 2006, The Rules Of Engagement).

Company News

I’ve written on numerous occasions Ericsson is the ultimate technology stock for the long run. And although it will suffer when the markets are weak, it deserves a place in a well-diversified, long-term growth portfolio (see SRI, 5 April 2006, A Good Start). Strong results from Ericsson’s joint venture (JV) with Sony (the companies sell cell phones under the brand name Sony Ericsson) underscores this assessment.

The JV’s numbers blew away market expectations. Sales came in 25 percent above the consensus forecast at #2.91 billion (USD3.6 billion) while income of at #433 million ($540 million) beat expectations by 100 percent. The JV is projected to contribute $270 million to Ericsson’s operating profits for the third quarter, numbers that will be announced October 19. Given that the holiday shopping season is just around the corner, don’t be surprised if Sony Ericsson accounts for an even greater share of the bottom line for the fourth quarter.

As time passes, more and more investors and analysts are realizing that Ericsson has executed a successful turnaround. A company that will benefit tremendously from the rise of China and India, Ericsson remains a core holding of the SRI Portfolio. It’s a “must have” for the 21st century global investor.

Singapore’s Keppel Corporation has secured two large contracts from Qatar’s Ministry of Municipal Affairs and Agriculture, amounting to $1 billion. As I’ve said before, oil-rich nations in the Middle East will continue to spend some of their money on infrastructure projects, and companies that are able to secure these projects will reap great rewards.

The two contracts are for the engineering, procurement and construction of an integrated solid waste management facility in Qatar and the operation and maintenance of the facility for 20 years from 2009, when construction is expected to be completed. The project is expected to handle and treat domestic solid waste for the whole of Qatar.

Alternative Holdings Portfolio recommendation Lukoil is making a presentation in New York today on its future strategic plans and will also announce financial results. Obviously the former item is of greater current importance.

A couple days ago, the Russian business daily Vedomosti (a co-project of the Financial Times and The Wall Street Journal) reported that Lukoil’s plan is centered around management’s decision to spend $115 billion on capital expenditures during the next ten years, with $61 billion to be spent in the next four years. According to Vedomosti, the plan calls for an increase in exploration and production, building a petrochemicals complex on the Caspian Sea, ramping up marketing efforts and targeting appropriate assets for acquisition.

If the reported numbers are legitimate–and today’s conference call from New York will shed a lot of light–then Lukoil’s management seems determined to substantially expand the company’s reach. I wouldn’t be surprised if Lukoil announces an expansion of its relationship with ConocoPhillips (NYSE: COP). ConocoPhillips holds a 16.1 percent equity stake in Lukoil and has made clear its intent to reach 20 percent ownership.

Finally, I’m selling PCCW from the SRI Portfolio. The merger-and-acquisition scenario I previously outlined hasn’t unfolded, nor do I expect it to happen in the impressive manner I originally envisaged. I’ll be looking for a different way to play Hong Kong.