Production capacity: Zero slack and in a balanced position
The below graph reflects both production capacity levels (the right axis) and the outlook (the diffusion index on the left axis) 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 production capacity has finally disappeared. This has been a long and painful process for the Japanese economy, though the below graph would suggest that the worst is over as far as excess capacity is concerned. Given the current trend, it’s conceivable that 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. (Note that the red line is an index with 2010 production levels equal to 100.) Perhaps these trends in improving production efficiency will continue, improving already strong corporate profits and further supporting the rally we’ve seen in the Nikkei since 2012.
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Post-2008: Did China over-invest while Japan under-invested?
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 rates that have faltered since 2008. As Japan’s growth bubble popped in 1990 and its currency had continued to appreciate since, there has been very little investment in Japan in terms of aggressively adding production capacity to meet future demand. However, as the above graph suggests, with just a little more growth, Japan will likely have to invest, or start running a little lean on the production side. In either case, such a progression would be a positive for the Japan economy—either in terms of new fixed investment, or potentially growth in wages and consumption.
To see how the fixed investment recovery in Japan is finally accelerating and supporting growth, please see the next article in this series.
For an overview of the U.S. macroeconomic recovery that could support Japan’s export economy, please see 2014 US macro outlook: The crack in the debt ceiling.
Japan’s equity outlook
As 2014 progresses, investors could see a continued outperformance of the 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). Plus, as Japan pursues unprecedented monetary expansion and the U.S. Fed tapers its bond purchases, Japanese equities could also outperform broad U.S. 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). For more on how the U.S. Fed’s recent announcements could impact global equities, please see Will the Fed take a bite out of Apple?