The Coming Week in Asia: Surviving in a Post-Rate-Hike Market

TOKYO -- As summer holidays draw to a close here and investors stampede back into the arena, the big question facing them this coming week will be how to play the Bank of Japan's rate hike.

First, they'll have to decide if the 25 basis-point hike was the start of a tightening cycle or a blow struck in the name of the central bank's independence, and thus a one-off occurrence. (A basis point is 1/100th of a percentage point.) Most market watchers believe the latter prompted the Aug. 11 rate increase, the first in nearly a decade.

With deflation still present in the economy -- consumer prices fell 0.7% in the year to June -- a round of continued hikes would not seem to make sense. Additionally, the rate hike will have sent a signal that the BOJ wants Japan Inc. to speed up the pace of corporate reform, but further hikes could derail that process by pushing too many companies into bankruptcy.

So far, the performance of the key Nikkei 225 index supports the view that more increases aren't in store. The index climbed 1.8% in the wake of the rate hike. That said, investors still have to navigate some treacherous waters. The 25 basis-point increase likely will put pressure on already teetering companies, especially in the retail and construction sectors. Questionable concerns now face the prospect of making tough restructuring choices in the months ahead or going belly up.

Given that many won't meet the challenge, cyclical stocks are likely to suffer even if a tightening cycle doesn't emerge. And banks, which already are under pressure from bad loans, could face further woes if bankruptcies mount. Fuji Research Institute reckons financial institutions will be forced to write off another 22 trillion yen ($202 billion) of bad loans over the next two years. That's money that banks, which are in the midst of a consolidation and restructuring process, can't spare.

Such bleak prospects are likely to dampen foreign investors' enthusiasm for the market. "At this point, I don't see foreign investors increasing their weighting in Japanese stocks at all," says Akio Sakanaka, CEO of Sovereign Asset Management, a financial consultancy that advises both domestic and foreign institutional clients. "That means the upside is quite limited."

So what are investors like U.S.-based Japanese mutual funds, which are down by an average of 19.5% so far this year, to do?

"If you're looking to invest, you have to stick with the basics," Sakanaka says. "Only put your money into firms that have profits, and that means electronics-parts makers and semiconductor manufacturers."

Many mutual fund managers agree. If you look at the top-10 holdings of some of the better-performing funds such as (GMOJX Quote)GMO Japan III and Morgan Stanley Dean Witter's (MSJEX Quote)Institutional Japanese Equities, they are chock-full of electronics-parts makers. Holdings include Canon (CANNY Quote), TDK (TDK Quote), Toshiba, NEC (NIPNY Quote), and Hitachi (HIT Quote). So far this year, the dependence on electronics-parts makers has borne somewhat-less-spoiled fruit for these funds. Although the GMO fund is up only 0.36% this year, and MSDW's fund is down 4.94%, both have outperformed the woeful Nikkei 225 index, which is down nearly 10% on the year.

Of course, there's a catch to this investment strategy. Operating profits for all electronics-parts manufacturers look set to break last year's 14.4% increase, but the stocks' popularity may make them riskier than they appear. According to research from MSDW, the major investors in Japanese equities -- foreigners, local pension funds and mutual funds -- all have topped up on the same stocks: electronic-parts makers, pharmaceuticals and service companies. So if one investor group suddenly has a change of heart in terms of industry allocation, the negative effect could be overly amplified.

"While potential net flows into and out of the market are large enough not to be ignored, the highly unusual position that has now been reached -- with every category of nonrelationship investors holding essentially the same portfolio -- is a feature of current market conditions more worthy of investors' attention," Alexander Kinmont, a MSDW strategist, wrote in a recent report.