Why '97 May Be Nasty For The Nikkei

A tight budget and deregulation are making investors nervous

Last year began in Japan with hopes that economic recovery would bring the country's six-year-long stock-market blowout to an end. Instead, 1996 ended bringing investors nothing but bad fortune as the Nikkei stock average plummeted 8% in December (chart), wiping out the modest gains scored in previous months. Worse yet, expectations of even more losses in '97 hung heavily over dispirited traders as they headed to hot springs and ski resorts for the extended New Year holiday.

Investors have good reason to be edgy. Faced with mounting government deficits, Prime Minister Ryutaro Hashimoto's Cabinet approved a tougher-than-expected budget on Dec. 25. It calls for flat real spending, will raise the national sales tax from 3% to 5%, and repeals an income tax rebate enacted in 1995. The measures are expected to shave $60 billion, or about 1%, from Japan's output in 1997--bad news for an economy that's already on the verge of recession. Fiscal tightening, sluggish industrial production, and pallid consumer spending should keep economic growth down to 1% in 1997, Nomura Research Institute estimates. Earnings growth is expected to slow to 5% in '97, vs. 15% in 1996.

Hashimoto's tough fiscal policy certainly means an end to headline-grabbing spending packages similar to the six programs that have pumped $560 billion into the comatose economy since 1992. But more than the prospect of continued economic weakness is souring investors this winter. What's really jolting them is the prospect that Hashimoto's high-stakes crusade to deregulate major sectors of the economy may be more than a clever public relations ploy after all. The Dec. 15 deal between Washington and Tokyo opening the protected insurance market to U.S. and other foreign competitors more widely than anticipated is now being seen as a harbinger of similar treatment for other coddled industries, including finance, transportation, construction, and retailing.

Indeed, even as shares of many multinationals were more than holding their own, it was a broad sell-off of companies in protected domestic industries that triggered December's market rout. The first to be hit were small brokerages and banks expected to fall victim to the "Big Bang" package Hashimoto announced in November to overhaul Tokyo's financial markets. Next came insurance shares, following Japan's surprise concession to open up its auto and commercial fire insurance markets. Then came other domestic sectors that now look vulnerable to more efficient foreign rivals. "A lot of Japanese companies cannot compete on a world scale," observes Paul J. Fraker, a Japan specialist at Brown Brothers Harriman & Co. in New York. "Many are going to go bust or get merged."

He and other pros now see the Tokyo market splitting into two camps: a select group of globally competitive multinationals and a legion of domestically focused players struggling to survive. "It's becoming more a market of individual stocks than a stock market," says Ian Burden, who runs HSBC Asset Management's Asian portfolios. For example, among companies hitting new highs in Tokyo during the December depression were Denso Corp. a leading maker of automotive electronic components and ORIX Corp., a savvy leasing firm expected to benefit from financial deregulation. Such world-class players as Toyota Motor, Honda, TDK, and Sony have also withstood the Nikkei's fall.

SAGGING YEN. One wild card in the market outlook is whether overseas investors will come to the rescue again, as they did in all three major rallies since 1991. With the government cutting spending and interest rates already at historic lows, it probably will take a lot of persuasion to woo the foreigners back a fourth time. Adding to their caution is the depreciating yen, now at a 45-month low of 116 to the dollar. A further weakening would leave foreign investors sitting on currency losses. If foreigners head for the exits in 1997, some analysts see the Nikkei falling below 18,000 for the first time since October, 1995.


To be sure, not all the news is gloomy. Banks have made big strides in writing off $260 billion in bad real estate loans. And the fact that Hashimoto is campaigning to open regulated industries is a long-term plus. But before deregulation spreads its benefits, there is going to be short-term pain for the economy and investors alike. Explains economist Mineko Sasaki-Smith of CS First Boston (Japan) Ltd.: "The budget isn't investor-friendly, earnings aren't good, and the economy is decelerating." Hardly bull market talk--even if 1997 is the Year of the Cow.

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