Is Japan’s capacity utilization signaling a bull market?
Bank of Japan's Tankan points to strong recovery (Part 3 of 6)
Japan’s production capacity levels and capacity utilization
The below graph reflects both production capacity levels and the outlook (diffusion index) for capacity utilization in all industries and the manufacturing sector. The decline in production excess capacity seen post-2009 seems to be developing a strong declining trend, which suggests that excess capacity is now being used. Given the current trend, capacity levels could reach the levels seen during the recent 2006 peak, pushing the capacity utilization operating ratio back to the 2007 highs as well, when the Nikkei was nearly 30% higher than it is today. Perhaps this trend will continue, further supporting the rally seen in the Nikkei over the past year.
China overbuilt, Japan underbuilt
Many of China’s industries are experiencing capacity utilization rates in the 70%-to-75% range, far below the 80%-to-85% comfort level. Given China’s rapid growth rate, aggressive investment was based on long-term estimates of global and domestic economic growth that have faltered since 2008. As Japan’s growth bubble popped in 1990 and its currency has continued to depreciate since, there has been very little investment in Japan in terms of aggressively adding production capacity to meet future demand.
“Abenomics” drives investment and production
However, in the past year, Japan’s yen has weakened roughly 30% under the “Abenomics”-driven reforms, and export profitability is also growing rapidly. It’s important to note that, despite the pick-up in corporate profits attributed to the weakening yen, real export levels from Japan haven’t changed much as a result. Overall inflation-adjusted export levels are still at August 2009 levels—the same levels seen in 2006. While real growth in exports has been hard to find in the post-2008 global environment, it’s quite possible that real growth could develop in Japanese exports if the yen continues to weaken on Japan’s unprecedented monetary policy measures under the Abe-led reforms.
And if real export growth starts, we can expect the above data to meet or surpass the 2007 peak levels. Unlike China, Japan, with a weakening currency that’s not pegged to the US dollar, might finally see a return to investment as excess capacity disappears. This would be a large positive for Japan’s flat domestic economic growth rate and add further strength to the recent rally seen in Japan’s equity markets.
Outlook
As 2013 progresses, investors could see a continued outperformance of Wisdom Tree Japan Hedged (DXJ) and the iShares MSCI Japan ETF (EWJ) versus China’s iShares FTSE China 25 Index Fund (FXI) and Korea’s iShares MSCI South Korea Capped Index Fund (EWY). For further clarification as to why DXJ could outperform both EWJ and other Asian equity indices, please see Why Japanese ETFs outperform Chinese and Korean ETFs on “Abenomics.” Plus, as Japan pursues unprecedented monetary expansion and the US Fed ponders monetary tightening, Japanese equities could also outperform broad US equity indices, as reflected in the State Street Global Advisors S&P 500 SPDR (SPY), State Street Global Advisors Dow Jones Index SPDR (DIA), and Blackrock iShares S&P 500 Index (IVV).
Please see related articles on Japanese consumption and Japanese investment.
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