John Vail, head of global strategy and asset allocation at Nikko Asset Management in Tokyo, discusses Japanese equities from a macro point of view.

Will the global trends of the past few years continue in 2007?
Yes but not with as much gusto. 2007 will witness more rocky conditions. It wonÆt be in a straight line. WeÆve had several years in which interest rates have been extremely accommodative. Central banks have been perhaps too gradual in raising rates. Global liquidity has been very beneficial to financial markets and economic growth.

WhatÆs different now?
Commodity prices rose too fast for the comfort of the central banks, especially for oil and gold. The bankers say they donÆt watch commodity prices, but I suspect they do. Property prices in many places also made central banks uncomfortable. They felt that risk premiums were too low, and they still are.
In the middle of this year the central banks began to make hawkish noises, which led to the correction in emerging-market equities in May and June. Fed policy is beginning to affect the housing market now in the United States. This will moderate consumer spending in the US, and therefore economic growth.

Are we headed for a recession?
No, monetary conditions are not so tight as to cause a recession. Commodity prices did come off and the Fed eased its rhetoric. There has been a pause in tightening rates. People are, however, now questioning the æperfect soft landingÆ scenario. Commodity prices have moved upward again. So next year is likely to be volatile.

So the global imbalances remain manageable?
Well, we donÆt see the US falling into a housing-led recession. Equity markets in America are generally up, perhaps more than we would have thought. But the big questions remain: where are the excesses in the global economy, are they being unwound, how long will Asian central banks continue to finance US deficits?

What about on the political front û is protectionism a threat?
The victory of the US Democratic Party in taking control of Congress is a big change. The Democrats will try harder to enforce existing environmental, labour and social clauses in AmericaÆs trade agreements. They donÆt need to pass new treaties or laws. They just need to insist on stricter interpretations of existing trade deals.

This is going to cause some waves. The Democrats need to show the electorate some tangible progress if they are to win the White House in 2008, and I think they will push this line harder than the consensus expects. China, of course, wonÆt sit back and let US legislators scream at them. So this is one reason behind our belief that next year will see more volatility and a landing of the US growth story that wonÆt be hard, but it wonÆt be as soft as many observers had hoped.

Is Pacific trade vulnerable, and will that impact financial markets?
It depends to what extent fears of protectionism feed into fears in the interest-rate markets that the US canÆt sustain its deficits. China doesnÆt want the US consumer to retrench. Globally, central banks are looking for a better balance, however, which means US external deficits must decline. ThatÆs hard to achieve without a moderation in US consumer spending.

Will risk premiums stay tight in 2007?
Risk spreads are too low for certain asset classes, but not in equities, where valuations are quite moderate. These typically widen in credit events, particularly in the fixed-income markets. We could see some real-estate defaults. US banksÆ exposure to real estate is extremely high û more than many economists on the Street realise. That could become a concern. IÆm not questioning the solvency of these banks, but it could impact their ability to lend. And US regulators are now forcing banks to be more stringent regarding risks to commercial real estate and exotic mortgages. Quite a few banks will have to curtail their exposures.

The stock market could also face a challenge if a private equity deal goes badly, because private equity has been a source of support for the markets. If those guys canÆt jump into real estate deals, there could be problems. But that said, it would take a slew of sustained bad news to really scare the stock market about real estate. And if there was a real problem, the Fed could always cut rates to boost economic growth.

So where does this leave equity investors?
Japan has been oversold. Investors there are overly pessimistic. The fundamentals look good from a bottom-up point of view, despite the poor macro numbers. Some people that had been bulls have ratcheted down expectations for earnings growth and the Topix, but we think the market looks solid.

Why did 2006 disappoint in Japanese equities?
It simply gave back the excess returns from the bull run of 2005, when markets rose 40% in local currency terms. This year the market fell 8-9%. In US dollar terms, it has given back its 2005 out-performance. Relative to global markets, weÆre back to where we were in 2003, when people still worried about the Japanese banking system. This seems too pessimistic to us and we believe that Japan should out-perform in 2007.

Why have Japanese stocks been so damaged?
There have been corporate governance issues. There is an increasing fear that Japan is not as open to mergers and acquisitions, the kind of deals that unlock shareholder value. The public demise of several corporate reformers û or greenmailers, as some call them û means the chance of unlocking that value has diminished.

So what will drive out-performance?
The biggest positive is dividends, which had fallen consistently during 1989 to 2003. They fell in 1999, even when earnings improved but now dividends are rising sharply. But Japanese people have begun to buy stocks as an investment because they want equity-income products. Individuals are underweight domestic equities but they are now catching up. Foreign investors also remain net buyers.

Dividend yields are now close to the yield on a 10-year government bond. Dividends have risen more than 26% in 2006, which is faster than corporate earnings. Japanese individuals love it, and companies have come to realise that raising dividends will shield their company from attacks by acquisitors. Also, we believe that when stock dividends are close to long-term JGB yields, the stock market is probably close to the bottom.

Are companies in better financial health?
Yes. Many Japanese companies have reduced debt to stable levels and are now borrowing again, moderately. Returns on equity are hitting new highs, as are profit margins.

What does all of this imply for Japanese stocks?
ThereÆs now hope that the government will allow triangular mergers, which will allow foreigners to use stock, not cash, for M&A transactions. And thereÆs talk that the capital gains tax will be extended. The PER on IBES consensus 2007 EPS is below 16. In sum, we donÆt think that the market will soar, but there is downside support and reasons to expect an equity rebound.