Bank of Japan's consequences on the world markets

Andrew Vaughan - Mon 27 Mar, 2006

...Developments concerning the Bank of Japan have yet to play out in world markets. But the consequences on the world markets could prove dramatic...

- Developments in Japan have yet to play out in world markets. But the consequences could prove dramatic. And Britain's stock market could be a major beneficiary.

- The Bank of Japan has suggested that its era of loose monetary policy has reached the end. Firstly, it will no longer flood Japanese banks with the liquidity which – when lent out at near zero percent interest rates - has helped to drive up market valuations around the world. So secondly, commentators and pundits around the world now expect an end to that "zero interest rate policy" soon, too.

- The BOJ has given no indication that it's about to kill of the ZIRP. But perversely, the yield curve in Japan – the chart of short-term rates versus longer-term rates – now anticipates a very aggressive increase in Yen lending rates.

Bank of Japan's consequences on the world markets: Japanese businesses

- What does this mean? Well, it is not good news for businesses in Japan - although there is plenty of good economic news to offset it. The news is broadly negative for the ASEAN region too. There, Japanese direct investment is significant.

- Hedge funds in London and New York will mourn the reduced availability of near-free debt finance from Japan. But the major equity markets outside of Japan - notably the UK and USA - are not being kept aloft by cheap yen finance. We see nothing to cause concern in the short-term. But certainly, some clarification of direction from the Bank of Japan would be welcome.

- Interest rates remain very much in focus for investors everywhere, in fact. The UK has kept rates on hold at 4.5% for the 7th month in succession; the ECB has increased euro rates by 25 basis points to 2.5%; and the US Federal Reserve has confirmed that further tightening is likely. On balance then, investors are looking at a backdrop of higher rate expectations. Yet despite this, equities, bonds and commercial property remain sought-after. Given the inflationary pressures now present – most especially from energy and commodity prices - real interest rates remain modest. The gap between base rates and inflation is tiny compared with, say, the mid-80s.

- So investors across the globe continue to embrace lower rates of return on capital. Indeed, in a world of shrinking real yields, quibbling over the rates of return paid by one investment over another can pay off handsomely. The recent approach by Nasdaq to acquire the London Stock Exchange, for instance, confirms that price has almost become an irrelevance in the quest for key non-replicable assets. BAA is another current takeover target that occupies a similar “toll-gate” position. The airports operator has such market dominance; it looks to be worth pretty much any price to the right bidder.

Bank of Japan's consequences on the world markets: The NASDAQ

- But take a look at what the LSE could do for Nasdaq's own stock valuation. NDAQ now trades on a price/earnings ratio of 71 times. That equates to an earnings yield of just 1.5% - a miserly rate of return! But the magic of course is in paying for acquisitions using paper that's rated so highly. Any target share bought on a lower P/E ratio automatically enhances earnings...and therefore it looks entirely justifiable to shareholders - whatever the price.

- The UK remains home to some key international businesses. With debt finance cheap and highly-rated stocks from overseas like Nasdaq looking to grow through acquisitions, London valuations actually look quite modest. The FTSE100’s weighting towards banking, oil and resources could set the scene for a further strong advance in 2006. Even Vodafone, a long-serving hand-brake on the FTSE index’s advance, has sparkled lately - with a strong share price advance from recent lows.

- The oil and resource story is well-rehearsed and set to continue, I believe. Banks, perversely, remain lowly rated and therefore should remain well represented in growing share portfolios. HSBC and Royal Bank of Scotland – two of the world’s largest banks – released fantastic results this month, with RBS increasing its dividend by 29%.   

- Emerging markets, however, have failed to maintain their broad advance. There is a chance that these more speculative and less mature markets have been pumped higher by the flood of cheap money starting in Tokyo. The small Middle Eastern markets have suddenly become newsworthy with the popular listing of Kingdom Hotels, the new Dubai exchange’s first equity offering. But in Saudi Arabia the Tadawal-All Share index just dropped 10% in ten days and other regional fledgling equity markets are down some 20% from recent highs.

- Thailand and Philippines have fallen into political limbo and South Africa has made worrying noises about preventing foreign ownership of land. Our own FTSE100, by contrast, looks a core pick for further strong investment returns in 2006. Even above 6,000, where the blue-chip index finally closed last week, there's value to be found.

- Comparatively speaking, at least!

Regards,

Andrew Vaughan
for The Daily Reckoning

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