Nasty Surprise Coming for Japanese Stock Investors

By: Money_Morning

Keith Fitz-Gerald writes: [Kyoto]-September's anti-Japanese protests in China over the disputed Senkaku/Daioyu Islands may have come and gone in the Western press, but the real damage is only just beginning for investors who have piled into Japan in recent years.

With their focus on the U.S. fiscal cliff and ongoing EU banking problems, many investors just don't understand how interlinked trade between China and Japan has become, nor the breadth of the damage this strained relationship can do to their portfolios.

But they're about to.

The breaking news here in Japan is that Honda cut its full-year net profit forecast by 20% following a 40% drop in September sales. That marked a 16-month low in sales that is directly related to nationalistic friction between the two nations.

That's adds up to a 95 billion Yen hit. To put this into perspective, Honda's net profit last year was only 211.4 billion Yen, so we're talking about a nearly 50% drop in the company's bottom line.

Under the circumstances, I would be very surprised if Nissan and Toyota, both of which also have significant operations in China, don't follow with similar results when they report next week. While I haven't seen estimates from Nissan yet, Forbes reports that Toyota sales are off a staggering 49% over the same time frame.

That's the biggest drop in a decade.

That's not inconsequential considering that Chinese-Japanese trade accounted for more than $340 billion USD in 2011. Japan is China's fourth-largest trading partner after the EU, the U.S. and the ASEAN nations respectively. It accounts for approximately 10% of China's total annual gross trade volume according to Xinhua.

On the other hand, China is Japan's largest trading partner and has been since 2007 when Japanese corporations dropped the U.S. market like a hot potato. China is also Japan's single largest export destination, accounting for nearly 25% of total export volume as well as the single-biggest source of its imported goods.

The damage won't be limited.

Big Trouble For a Wide Range of Players
I expect Japanese airlines and Chinese airlines to hit turbulence, too.

Since the widespread violence in China this fall, legions of tourists and business travelers alike continue to cancel trips. While Japanese travel agencies report a drop in bookings to China, Chinese agencies are getting out of the game altogether and it's not just the bit players, either.

Xinhua reports that China International Travel Service Limited, China Comfort Travel and China CYTS Tours Holding Co., Ltd., have stopped selling travel to Japan entirely.

Reports here suggest that Nippon Airways Co., Ltd. and Japan Airlines Co., Ltd. cancelled upwards of 20,000 seats on routes into China in late September and early October. It is not clear if -- or when-- they will be added back into flight operations.

At the same time, Chinese airlines, including Air China, China Southern and China Hainan Airlines, have also cancelled flights and cut seats to Japan while also postponing valuable new routes to both Sendai and Okinawa.

Anecdotally, my friends tell me that many formerly full flights between the two countries are half full at best.

Japanese home appliance makers are not immune, either.

Panasonic, Sony, Hitachi and Sanyo are all likely to experience an earnings impact in the months ahead.

Executives I spoke with this weekend, who wish to remain anonymous because they are not authorized to speak on behalf of their companies, suggest that monthly sales in Chinese retail outlets could be off 45%-70% by the time the damage is "done."

I pressed for clarification as to when that might be and didn't get any officially. But their cold silence spoke volumes about what they expect through year end.

For Every Loser, There is a Winner
So what do you do about this? That depends on four things.

First, the situation is unlikely to go away any time soon. In fact, I believe it's going to play out well into the fourth quarter. Any Japanese company doing business with China is at risk.

Many are names you know, but if you have invested in Japanese ETFs like many investors have, there are a lot you don't know, too. This is particularly true if you factor in the extensive supplier network of second- and third-tier Japanese companies behind such well-known names as Mitsubishi, Honda and Toyota.

Second, China plays the nationalist card at its discretion and tacitly fans the flames whenever it is convenient. Its citizens, many of whom have yet to grasp the subtleties of international politics because their view of the outside world is extremely limited, react predictably when they perceive they have been wronged. So the situation and its impact on earnings is unpredictable at best.

Third, there is the very real and growing possibility that China will use military force to take the Daioyu Islands back. Since 1949, China has been involved in 23 territorial disputes and has used force in six of them - all of which resemble the Senkaku/Daioyu dispute, according to M. Taylor Fravel, an associate professor of political science at MIT and the author of Strong Borders, Secure Nation: Cooperation and Conflict in China's Territorial Dispute (Princeton, 2008).

I agree. Beijing is under pressure to produce favorable results at a time when its leadership faces a complicated transition, slowing economic prowess, unprecedented fallout from the Bo Xilai situation and other prominent scandals that have rocked the very top of the Communist Party -- including recent revelations that Premier Wen Jiabao appears to have amassed a $2 billion fortune illicitly, using his position to gain wealth and power.

Fourth, I am hard pressed to imagine how Japanese companies can come out on anything other than the losing end of the stick no matter how the Senkaku/Daioyu Island situation plays out.

And with more than 20 years of doing business in this part of the world, that's not an easy conclusion for me to reach.

Japan has built its entire economy on exports for decades and the conscious shift to embrace China in the late 1990s will haunt Japanese corporations for a long time to come if Japanese and Chinese leaders cannot come to some sort of agreement.

If there is a bright spot it is this: Capitalism works because there are ebbs and flows in capital markets that are caused, many times, by factors well beyond rational expectations.

That means there for every loser, there is a winner.

I expect German and Korean car makers to immediately fill any gaps left by pressured Japanese automakers. Both VW and Hyundai come to mind, for example. GM and Ford will both make competitive moves as well if they're smart.

In like fashion, other non-Japanese, non-Chinese air carriers will move to service demand if it resumes. This will allow both nations to draw closer together without either losing face by directly "serving" the other.

Home appliance makers are more problematic in that both industries are effectively commoditized at this point. There is very little in the way of technology or other competitive advantage that can't be taken up by local Chinese companies.

Perhaps that's an opening for American manufacturers if the upcoming anti-Chinese presidential election rhetoric doesn't effectively tank them, too.

Source :http://moneymorning.com/2012/10/30/investors-who-own-japanese-stocks-are-about-to-get-a-nasty-surprise/

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