Last week, the Bank of Japan (BoJ) announced its latest measures to try and stimulate the economy.

The plans were bolder than expected with the Bank saying it would aggressively pursue a 2% inflation target. Japan has been caught in almost two decades of on-and-off deflation, or falling prices.

The news saw the Japanese stock market, the Nikkei, hit its highest level in almost five years, a sign that investors approved of the positive rhetoric coming from the Japanese Government.

Adrian Lowcock of Hargreaves Lansdown says: “The initial reaction of the Japanese market says it all; it reversed a fall to a 2% rise.

“Stock markets tend to respond positively to more quantitative easing (QE) as it should drive risky asset prices, such as shares, up. And with this round of QE targeting riskier assets it is likely to be good news for the Japanese stock market.”

So, should UK investors be flocking to the Land of the Rising Sun?

The Japanese equity market has spent years in the doldrums, with the 2011 earthquake and tsunami only adding more pressure to a struggling export market.

However, fund manager Nathan Gibbs, who runs the Schroder Japan Alpha Plus fund, says the BoJ’s decision to aggressively clamp down on deflation is positive for foreign investors:

“The new policy direction from the Bank of Japan means that Japan is more likely to exit from deflation and is therefore positive for investors in Japanese equities.

“Whether Japan can really achieve the stated inflation target of 2% within two years is still very uncertain, but the chances are better now than they have been for many years.”

Gibbs believes the Japanese equity market has appeared undervalued for some time, and the general election in December 2012 has provided a catalyst for some of this value to be realised.

The recent political activity has been a boon for Japanese equity funds.

Japan funds account for 8 out the 10 best performing funds so far this year. The Nikkei has notched up 19% return over the first three months of 2013, despite remaining well off record highs.

Gibbs continues: “Of course, after such a strong rebound from the lows seen in 2012, we can expect some periods of consolidation or correction.

“However, given the apparent new policy direction from both the Government and the Bank of Japan, we should see positive news flow continue over coming months and this should support the equity market.”

The next key event will be the elections for the Upper House in July and the Government has every incentive to maintain its current momentum until then.

However, there are still concerns for sceptical investors.

Top performing Funds March 2013 – 

  Source: LIPPER 28th February to 28th March 2013

In the long term, structural issues like Japan’s large fiscal deficit and its falling population numbers continue to weigh heavily.

Japan is the world’s most indebted economy.

It would also be reasonable for investors to expect the recent political activity to be short-lived. Investors in Japan Inc. have been promised many new dawns and politically-led shake-ups in the past two decades. None have delivered.

Yet experts believe the negatives will be outweighed in the near term by improvements in the economy and the better prospects for an end to deflation.

Corporate governance is another concern, but the bullish view is this should not be a major concern for investors in the near term. While some isolated negative events have made the headlines, the underlying trend is actually for a general improvement in corporate governance, albeit at a rather slow pace.

Investors should also note that although Japan has taken the right direction in its own policies, it still remains vulnerable to external influences.

Gibbs says: “Aside from temporary factors such as a further deterioration in Japan’s relationship with China, there is a risk that global economic growth, and especially US growth, fails to meet current expectations.

“In this case we could see upward pressure on the currency which would delay some of the improvement expected in Japan’s corporate profits.”
But for investors looking at the short-term picture, the depreciation of the yen is key to Japanese growth. The Japanese yen dropped to its lowest level since 2008 against the US dollar today after the beginning of the new stimulus measures.

Analysts at fund management house, BlackRock, point to similar ‘euphoria’ in the Japanese stock market after monetary policy of a similar magnitude in the early noughties.

Global strategist, Dan Morris, says: “It is not more aggressive monetary policy but economic reform that is necessary to restore the Japanese economy to health. The initial euphoria following the election in 2005 was eventually replaced by disappointment and a resumption of Japanese equity market underperformance. Avoiding a repeat is the biggest challenge facing the Japanese government today.”

Investing in Japan will remain a risky option for quite some time yet, but if the Bank of Japan can pull off a defeat of the country’s deflation, then investors willing to take the risk may stand to enjoy the benefits.