Still bullish on Japan in the medium term?

This time last year markets were swooning over the Japanese prime minister, Shinzo Abe's, package of reforms, known as Abenomics. In fact, the Nikkei 225 was the top-performing developed market index in 2013 and, coming into 2014, many market commentators, including Chelsea, tipped the Japanese market for further gains. However, the Nikkei has traded sideways for the last few months and there is now talk that the big asset allocators, such as global macro hedge funds, are starting to lose patience. I thought now would be a good time to re-evaluate the prospects for Japanese equities and analyse what might be the catalyst to push the Japanese market higher.

While everyone understands that markets don't go up in straight lines, it has been almost a year since the Nikkei ended its spectacular run, which had started in November 2012. With markets' obsession with short-term trends it is perhaps not surprising that people are starting to get frustrated. Also, there have been other factors appearing in recent weeks that have poured cold water on the Japanese bull story. Firstly, at the start of April, the Japanese government are going to raise the consumption tax. The last time such an increase was implemented it choked off consumer spending (albeit in conjunction with the Asian crisis in 1997) and stalled the recovery. There is a fear that this rise may have the same effect.

Secondly, the panic that gripped emerging markets in January led to investors dumping Japanese equities and buying the yen, due to its perceived status as a safe haven currency. As over half of Japanese exports go to emerging markets it is easy to see how turmoil in these countries could derail Japan's nascent recovery.

Thirdly, GDP growth in the fourth quarter of 2013 was forecast to be 2.8% but came in at a rather disappointing 1%.

While I accept all of these are valid arguments I still have a bullish medium-term view. After all, we raised our consumption tax in the UK (VAT) during a recession and no-one so much as batted an eyelid. I see no reason why Japan can't do the same. The concerns regarding emerging markets are completely justified but it is a revival in domestic demand that will determine whether Abenomics will be a success, not the strength of emerging markets. Lastly, the GDP growth figure was skewed by energy imports caused by the shutdown of Japan's nuclear power stations.

In short, it is too early to tell if Abenomics is working as it has really only just begun. I think if the market sees an increase in inflation (and there are early signs that this is already happening), which spurs domestic consumption, and filters down to corporate earnings, the market will, in my opinion, move higher. Also Japanese retail investors hold around 55% of their savings in cash. If inflation starts eroding their savings it may, in due course, force them into riskier assets, such as equities. Furthermore, if you throw in that more women are soon to be entering the workforce as a result of employment reform and Japanese retail investors are being encouraged to buy Japanese equities with the newly-launched Nippon ISA, it is not unreasonable to formulate a bullish medium-term view. Investors would be wise to remember that patience can often be rewarded with healthy returns, especially as Japan is still not only cheap versus other developed markets, but earnings are still growing.

By Harry Driscoll, senior research analyst, Chelsea

Past performance is not a reliable guide to future returns. You may not get back the amount originally invested,and tax rules can change over time. Harry's views are his own and do not constitute financial advice.

Published on 10/03/2014