Expert View: Waiting for take-off in the land of the strange clouds

Japan never ceases to surprise and often appears unintelligible
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The Independent Online

Tokyo always reminds me of a supersized Birmingham. Comprehensively erased in 1945, it is now an endless vista of identical 1960s office blocks. True, it is different from Birmingham in one crucial aspect - Tokyo is considerably less cosmopolitan. I have never understood the fascination this city can exert over the likes of style-guru Tyler Brûlé.

Japan experts so often get it wrong. Japan never ceases to surprise, and often appears alien or unintelligible. After one successful meeting in Tokyo, a client leant across the table and asked: "What is your blood group?"

Bewilderment is also an appropriate response to the Japanese stock market. After years of decline, reflecting the slow, painful torture that deflation was inflicting on the economy, the market suddenly came to life in 2005 in expectation of recovery. Indeed, in the fourth quarter of 2006, GDP growth approached the giddy heights of 6 per cent and much longed-for inflation seemed to be just around the corner. Japan is, of course, the only market in the world where investors actually want inflation.

This economic recovery does seem to be intact - it just appears to be taking for ever. That was confirmed on Friday by the Bank of Japan reiterating a forecast of 2.1 per cent GDP growth for this year, while at the same time admitting inflation will be lucky to be much above 0.1 per cent.

When oh when, ask the currency markets, will things speed up and Japanese rates rise?

The yen languishes at 120 against the dollar and the stock market itself has been decidedly lacklustre. The index actually lost 1 per cent in the year to the end of March in yen terms. For sterling investors, it was down 14 per cent.

What is going on?

Enter that major player in global markets, one of the world's largest pools of liquidity - the Japanese housewife. She it is who, in concert with London hedge fund managers, has been fuelling the "carry" trade - selling her yen to buy high-yielding currencies such as the New Zealand dollar. Far too large a slice of Japanese is are actually holed up in Auckland and the like.

It is also the Japanese retail customer in general who has created an extraordinary bear market in smaller Japanese companies. The appropriately named Mothers index of smaller technology stocks is down nearly 70 per cent from its highs at the start of last year, and collectively the small-cap index has underperformed the overall market by around 20 per cent in that period. Strip them out and overall returns would have been much higher.

The reason Mrs Watanabe has been selling with both hands is her disgust with the Livedoor scandal. This, you may recall, was the acquisitive smaller company which was dramatically raided at the start of last year, and whose chief executive, Takafumi Horie, was arrested. He and his bikini-clad model girlfriend had once been media darlings, touring Rappongi in his Ferrari. But the podgy-faced, spike-haired tearaway went down last week, thanks to emails found on his girlfriend's computer.

The emails made it clear that Livedoor had deliberately cooked the books. A loss of 300m yen (£1.3m) one year was reported as a profit of ¥5.3bn. While the rest of the world discovered "risk ignorant returns", Mrs Watanabe headed for offshore cash.

Fortunately, the distressed selling of some stocks has started to look like the fire sale that must herald the bottom. The fundamentals behind the smaller section of the market as a whole appear sound: profit growth of over 20 per cent for the next two years, nearly three times what's expected of large cap. At the same time, the valuation of the small section is the lowest it has been for a long time relative to large caps - the inverse (as so often in Japan) to what has been happening in other world markets.

When will Mrs Watanabe buy? Now there's a Japanese enigma. On Thursday, a Japanese lady asked me: "Don't you think the shape of the clouds strange this morning?"