All eyes remain on the household sector and overseas economies. So the large picture looks less promising than the perspectives of single companies. But the optimism of Japan's corporate leaders is not unfounded. Stocks will likely be strong again after the current slowdown has been digested.

The scandals at venture investment companies and consumer loan companies have further put off major retail investors and funds. Governance issue are still a very sensible topic in Japan's market. But we also had a shift from small caps to large exporters because of the weak Yen and underperformance of the domestic economy. At current prices, I think that there are many excellent companies and ventures that might be worth a second look.

There is little chance for a rate hike today. The BOJ has been stressing throughout the year that sound communication with other market players is at the top of its agenda. So we will have to watch the speech of Mr. Fukui for hints on a rate hike in January closely. But if market sentiment remains as weak as today, there is little chance for a rate hike even in January.

There is continuing strong concern about Japan's huge public debt within the BOJ, and the household sector will not increase its consumption unlike it sees higher income from its financial assets. A rate hike might also stop the continued weakness of the Yen. The negative impact on the corporate sector would also likely be limited.

The tax break will have very little impact because it will terminate in 2008 while Japanese households are looking for long-term investment opportunities. Economic policy of the new government still looks pretty murky, but the government at least seems to try to not to make any major economic mistakes. Especially the continued pressure on budget and bond issuance cuts leaves room for optimism. Although there are many signs that “old-style” LDP polices are returning, it needs to be pointed out that “old style” LDP policies, despite the 90’s policy disaster, have rarely been a direct obstacle to corporate performance. The more general and rather long-term problem is that “old-style” LDP policies won’t be able to revive Japan’s household confidence and solve the – many – remaining structural problems.

Confidence is at high levels already, so there is little room for further gains in the diffusion index. Especially capital investment plans at large manufacturers are extremely strong. The companies expect continued strong demand from Asia and the U.S. This optimism is reinforced by the fact that an expected Yen appreciation has not materialized so far. The companies are now more optimistic that external demand remains strong while the domestic economy improves gradually.

The companies are gaining from long-delayed replacement investments. The IT sector is booming for example. The companies also start to see the effects of increasing household demand at restaurant and the department stores. Also, real estate investors still try to lock in current low interest rates. Finally, financial and employment conditions are still positive for small corporations, so the companies remain optimistic that the strong economy will continue to tickle into the household sector and stronger demand.

Investment at the large manufacturers is very strong. But much of this investment is still driven by replacements in capital stock and overseas investment. Non-manufacturers and smaller companies tread much more carefully. Since companies also see little chance to increase output prices, the risk of general overheating remains limited.

Since companies focus on external demand and investment, the exchange rate and interest rates are the obvious risk factors. But both risks are rather limited. Bond demand remains strong, inflation low, and the BOJ careful; so interest rate hikes are not a major risk. The Yen can appreciate at anytime. But corporations now have a much more balanced international production network; so exchange rate risks look limited as well. The companies will be strongly taxed by high raw materials prices and tax hikes, however, so their profits remain sensible to any changes in demand conditions.

The BOJ has warned that it would react early on any sign of investment overheating. On basis on stronger inflation and investment data, an early interest rate step has become much more likely. But the situation is more complicated. Inflation pressures and investment plans are still strongly linked to overseas demand, not the domestic economy. So the BOJ needs to be very careful to not harm domestic demand while deterioration of overseas demand remains to be a risk factor. A likely current scenario is that the BOJ comments on an end ZIRP as early as next week, moves in August or September, but keeps rates surprisingly low.

Central banks have been on their toes to increase interest rates this year. This was possible because the economies are booming. But I expect concerns about the negative impact of oil price hikes to return from now. So central banks from Korea to China and Japan will have a close eye on domestic demand and growth as well. Further rate hikes might come later than expected.

Current interest rate hikes have focused on an early end of ZIRP. The 10-year benchmark bond is already overshooting average loan rate movements. I do not think that the BOJ is happy with this development and will not allow interest rates to increase too fast.

Most economists are now very bullish about the economy. I rather think that inflation risks remain limited and that the BOJ is becoming increasingly concerned about the fast hike of benchmark interest rates. It will rather wait and see if the economy remains strong into the second half of the year. September-October remains to be a good time for its first interest rate step.

Besides the usual declaration about international imbalances, the concern will be about growth risks from oil prices and interest hikes. This might help to end automatic interest hikes internationally, and induce central banks to further watch the economies before venturing into further interest steps.

Policy in China seems to be well on the way towards further market reform. Capital account regulations will be relaxed further and investment possibilities expanded. This won’t weaken the Dollar, however. The main offer that might come from Mr. Hu is therefore to expand domestic demand further. This is risky because the economy is still at the edge of overheating. But it is also what investors really like to hear.

If inflationary pressures are building up in Japan, as they do in the U.S. or Europe, the BOJ will certainly react early. But with inflation pressures still limited in Japan because of low household demand, the BOJ will rather remain busy with mopping up liquidity and technical adjustments in the money market before they increase policy rates. It also seems smart to keep the government happy by waiting until it announces the end of deflation in September for its election campaigns.

We finally got some dynamism into the bond market. Interest rates have certainly risen faster on back of the strong economy and overseas tightening. But current sell-offs in the bond market also reflect a spillover of inflation expectation from the U.S. and EU. Inflation risks are still quite low in Japan, so demand for bonds will likely remain strong. Pension funds will pour more cash into bonds after stock market valuations are already quite high, and banks will start buying again to allow for higher interest rates on savings accounts.

Confidence is at high levels already, so there was little room for further gains. Companies are carefully weighing risks, which is a positive development. Production continues to increase, investment is firm, and conditions for midsize corporations are improving. All this adds to a positive outlook for the domestic economy. Additionally, the Yen remains weak, while demand in Asia is increasing. So there is lots of room for optimism.

Domestic demand is increasing gradually, overseas demand in Asia remains strong, and inventories have come down a little. But companies still see little chances to increase output prices, so risks of overheating are rather limited. On the contrary, companies are still focusing on a rather careful mix of expansion. They still have high cash balances and are increasing dividends to keep investors happy. And they continue to expand overseas in Asia where demand is increasing faster than in Japan.

Corporations see a tight labor market, and oil prices are still weighing on profits. All corporations also remain sceptical about the sustainability of the low Yen exchange rate, and they expect increasing interest rates. It also seems unlikely that household demand will increase significantly any time soon. Coming tax hikes might even result in a significant fall of domestic demand. The companies will certainly be kept on their toes.

Yes. Not only producer prices are up, domestic demand continues to increase, which will further increase consumer prices. In today’s producer price report the disaggregate figures for demand levels show, that final and consumer goods prices are growing strongly. This comes on top of strong capital spending and export demand, so the Japanese economy seems to have entered a very healthy cycle. The BOJ might therefore upgrade its forecast for real growth this fiscal year beyond the current to 2.2%. It will stop short of ending its quantitative easing policy at the next meeting, however.

As early as April. The business cycle looks rather strong, so long-term expectations and long-term interest rates are the key for BOJ policy. Few people are talking now about Japan's 160% public debt, but to keep this mountain of debt manageable, the BOJ needs to keep interest rate expectations at the long end low - and the government on its toes to continue spending cutes. Though tighter monetary policy might increase rates at first, it would help to keep long-term expectations and interest rates from increasing too fast. So the BOJ will probably want to end QEP a bit earlier than absolutely necessary, but continue with ZIRP.

Japan will probably never become a frontrunner on liberal agricultural policy. But policies are currently under reform here, and general subsidies will be cut back. Furthermore, Japan needs to implement a more industrial and liberal approach towards agriculture because of Asian FTA negotiations anyway. So Japan will likely follow U.S. the stance towards subsidy and tariff cuts for the WTO meeting. It therefore really depends on progress in the EU's position now.

Trade will dominate this week's agenda in Asia, but no explicit positive bang is in sight. After Mr. Bush did not succeed with the Free Trade Area of the Americas (FTAA) in Argentine, progress on the WTO Doha round and a positive contribution of the U.S. in trade talks has become an even more important issue. Mr. Bush might also informally try to get Japan, China, and South Korea closer together again, to get some tangible results on FTA issues in Southeast Asia. But even top-agenda talks on IPR and tariff procedures will continue to move slowly.

In APEC, supporters of Doha-Round success have a majority, so there will certainly be a positive message to increase efforts for Doha-round deliberations. But singling out the EU as an obstacle to progress is also unlikely to produce positive results as long as France remains busy with its riots at home. So it is unlikely that the WTO Hong Kong meeting will yield any major results.

Japanese corporations are still expanding their production bases in Asia. For the first half of FY2005, the balance of foreign income is up by 23.7%, and the balance of income on FDI exploded by 61%. In China, monetary policy remains to be expansionary to boost domestic demand and imports. In addition, the weak Yen is now helping Japanese exporters not only against Dollar-based China, but also against East Asian competitors.

Domestic demand is still weak and restructuring keeps pushing prices lower. Next year, utility charges will be lowered again, and the regular re-basing of the CPI index will push down inflation figures again. Stronger exports and lower oil prices are therefore necessary to keep corporations optimistic about their investment plans, which is the key to push the economy out of deflation.

The government has realized that quantitative easing policy is finally producing strong positive effects by pushing the Yen down against (all) other currencies. Japan’s banks are flooding financial markets with Yen while buying higher-yielding foreign bonds. Foreign investors, in return, are recycling these Yen into Japan’s stock market, which drives optimism in Japan. This is very attractive for Japan's government, of course. But it is not the policy target of the BOJ. The BOJ will therefore continue to stress that quantitative easing is an emergency measure, which will end with positive CPI figures next spring. It will also continue to calm markets, however, by keeping its zero interest rate policy until the deflation trend has been broken by at least three months of positive CPI gains.

The current investor focus remains to be the interest rate differential to the U.S. It is very unlikely that the BOJ will tighten policy prematurely – despite internationally increasing interest rate trends. The current hawkish BOJ comments are basically targeted towards the Japanese government, which is in the middle of compiling budget and restructuring plans. The BOJ wants the government to keep public spending in check during these negotiations – despite its zero-interest rate policy.

Prices are even on the edge to get into a negative trend again. But on back of positive trends in domestic and foreign demand this seems unlikely. November figures should be stronger because earlier price cuts for some utility charges fade out. Companies are also positive for the outlook of this year’s Christmas and New Year sales, which seem to focus less on lower prices than before.

Investment demand is currently driving the economy in Japan. Service sector activity has remained strong during the recent downturn and industrial production is recovering. On the back of high cash flows and low interest rates, corporations are content with positive trends in domestic demand, although the overall level is still too low. So investment continues to focus on overdue replacements of outdated capital stock, R&D and on products with strong demand prospects. With increasing bank lending, this trend is likely to continue – despite high costs from oil imports.

The trade balance on a seasonal adjusted basis is expected continue its fall towards its 2001 lows. But the main drivers continue to be oil prices and worsening ToT from the low Yen exchange rate. For exports, the trend remains to be positive. The current investment boom in Asia and the low Yen are helping Japanese exporters. Both trends will continue to be positive for the economy and make up for some weakness in domestic demand.

Asia’s regional investment boom now gets some help from increasing domestic demand. In China, and now Korea as well, the economies are growing stronger than expected. This regional focus and outdated capital stocks in Asia will fuel the investment boom well into next year. But companies are certainly betting on lower oil prices for next year.

Over the last quarter, especially foreign investors have concentrated on positive news from Japan, while Japanese corporations remained concerned with the impact of oil and material prices. But Japanese companies also see supply and demand conditions as still positive. Inventories are falling, and companies did not revise their profit outlook downward. And most importantly, investment plans remain intact as well. So it seems likely that Japan continues to grow despite strong inflation in the material sector.

Especially the mid-size companies are hit hard by increasing input prices. But even they expect their profits to increase further, and they have continued to revise their investment plans upward to almost the same levels as major companies. Furthermore, the important story is that small enterprises are starting to invest more and see their employment levels as insufficient. So investment plans are likely to push domestic demand higher while households are waiting for improvements in their income situation. It is very likely that households will react to this improvement of business activity and employment by increasing their demand.

Although material prices are holding back the economy, we now have a very strong mix of positive domestic business conditions. With continued investment especially at the level of small and mid-size corporations, household demand will finally recover. Furthermore, corporations, especially in the non-manufacturing sector, see income and profits increasing. So there is a good chance that deflation will finally end, which would further increase domestic demand towards a self-sustaining recovery.

Japanese investors have already been showing a growing appetite for higher yields and risks. But they have recently concentrated on diversifying into foreign bonds. With the recovery now spreading towards more companies and the broader market, Japanese investors are likely to return to domestic stocks. This should result in a positive after some possible profit taking of foreign investors.

The BOJ seems to be convinced that Japan’s recovery is for real, and has been testing the market with hawkish comments recently. But central bank action seems to be unlikely anytime soon. So there won't be any support for the Yen from short-term interest rates. But Japan's current growth story looks increasingly convincing, which will support interest rates and the Yen from the market side already during the current quarter.

The situation in the Philippines looks more stable this week. The pillars of stability or regime change in the Philippines, the military, the church, and public movements in Manila, are still not interested in sacking president Arroyo. The lack of alternatives is still on her side. But the important plans for increasing VAT, which have already been shelved by the courts, have almost no chance to succeed anytime soon. The budget is therefore likely to run out of control at a time when inflation is driven up by oil prices and demands for further gasoline subsidies. Oil prices have become a major risk not only for economic but also political stability in Asia in the meantime. Thailand, and to a degree Korea as well, are at risk of running into vicious cycles of price-wage increases or major union demonstrations if governments try to reduce unsustainable gasoline subsidies without agreeing to wage increases.

Corporations remain optimistic about foreign demand, and there are clear signs for a domestic recovery beyond investment demand. Most hopes are pinned on a recovery in the non-manufacturing sector. So the, still moderate, decline in machinery orders from the manufacturing sector did not cause a major deterioration of business sentiment.

Although the current account balance in May is certain to have continued to fall, it will likely have only a limited negative impact. The fall in May exports is already known from trade balance data, and reactions on oil price hikes have so far been calm in Japan. The seasonally adjusted current account balance is also expected to find support from the strong dollar, which increases profits and interest income in yen terms.   

The BOJ is indeed likely to become less optimistic about capital investment as an “engine of growth.” But more importantly, it will probably upgrade its view on domestic demand because of increasing consumer demand and strength in the non-manufacturing sector. At a meeting of regional central bank office heads, most regions reported a gradual recovery. Regional banks have already started to expand their credit balances again, which further supports optimism in the SME sector.

The lower house vote on postal privatization has already been embarrassingly narrow for Mr. Koizumi, who has linked his political future with the success of postal reform. The bill now has to pass the upper house, where the ruling coalition has only a majority of 18 votes. But although reform opponents are likely to dominate the debate for the next week, it seems likely that Mr. Koizumi's LDP will be able to close ranks in last minute deals to avoid crisis.

Asian countries are greatly extending their foreign M&A for different reasons. Japan's companies are extending their production networks, and Japan's restructured banks need to expand internationally again. This is a positive and profitable trend. Similarly, developing country exporters need to expand their presence abroad to remain competitive by boosting their technological skills and presence in customer markets. But currently the wave is also driven by high liquidity in overly regulated Asian markets, as in the case of China’s state owned companies. Such investments are likely to resemble Japan's boom-and-bust takeovers in the 80s. Finally, the takeovers of resource and material companies by Chinese companies resemble the Japanese venture into Middle-East oil during the oil price shocks of the 80s. These investments were supported by national security considerations, and have not been very profitable as well.

Manufacturers are now shifting from restructuring to investment, which gives a major push to the domestic economy. More important is, however, that business sentiment at non-manufacturers has been improving from 1998 throughout two full business cycles. The service sector is now the most optimistic since Japan’s bubble burst in 1990. Services will likely get another push because the economy is now heading out of last year’s mini-recession..

Increasing investment is a sign of improving profit margins, which have been improving since the mid-90s in the non-manufacturing sector. Currently, the non-mfg SME sector actually has the most optimistic forecasts for FY2005 profit growth. But the economy cannot recover on basis of investment alone. It is therefore a promising sign that retail trade is recovering and that construction orders at major constructors are heading into positive territory.   

In the Tankan, the industrial machinery sector is the most optimistic, followed by information services, which is also one of the sectors that is more optimistic in its forecast for September. In general, restructuring now seems to be in its final stage, so the focus will be on companies with strong investment plans and growth strategies. The automobile and electronics sectors already seem to be well positioned. The real estate sector is already booming, while trade and construction recently saw the largest gains but these sectors remain dependent on a final recovery in the domestic economy. On back of a domestic broadband and mobile communication revolution is Japan's information sector booming. This sector will further gain from strong infrastructure investments of the banking sector. E-services have grown very strong and will soon improve their international market position.

Despite continuing deflation in sectors where restructuring remains in full swing, innovative companies are now able to pass on increasing material costs. On back of increasing material prices, wholesalers are now the first to see deflation to recede.