Intriguing Japan has positive outlook for year ahead

Japan will be one of the most intriguing areas for investors in 2015. After two decades trying to stave off deflation and promote growth, it is finally taking some dramatic action.

Prime minister Shinzo Abe has even called a snap election aimed at cementing support for his "three arrows" of economic recovery, while the Bank of Japan has finally joined the recovery effort with a huge programme of quantitative easing (QE).

But there is no guarantee that it will work. Alexander Treves, head of Japanese equities at Fidelity, sums it up.

"There are currently three questions around the outlook for the Japanese economy. First, will Abe succeed in returning Japan to inflation, after a generation of stagnating prices?

Impact of QE

"Second, will that inflation be broadly spread through the economy, resulting in a generally healthier attitude towards risk-taking and investment, or will there only be pockets of inflation, causing imbalances within the economy? Third, in its parallel aim to shrink the fiscal deficit, will the government hike consumption tax again, and with what consequences?"

He believes that the scale of its QE - in October, it announced an increase in the scale of annual purchases to 80 trillion yen a year (£430 billion), from the previous 60 to 70 trillion yen - "is bound to have some impact", although he adds that it is hard to judge how broad that impact will be.

"Will inflation boost activity and therefore corporate earnings, to be passed on in higher wages, which then further boost activity in a virtuous cycle? Or will inflation cause the average person's real income actually to fall, as wage increases lag behind price rises? Clearly that would be a significantly less benign outcome."

He expects real wage increases and therefore increased spending power over the longer term, but it may take time to fully play out.

The answer to the third question depends in large part on whether Abe decides to go ahead with the increase in sales tax from 8 to 10%, which was initially planned for October 2015.

A rise from 5 to 8% in April 2014 was seen as a key factor in pushing the country into recession in the third quarter. Treves worries that the QE increase means Abe is going to go ahead with the rise, albeit delayed - Abe is committed to introducing it in April 2017.

Currency

Paul Niven, manager of the Foreign & Colonial investment trust, thinks that the Japanese currency is crucial to the outlook. He points out that, while the Nikkei index rose in local currency terms last year, the yen's fall - it has depreciated around 30% against the dollar - means UK and US investors have actually lost money. His trust has used a policy of shorting the yen by borrowing in that currency to counteract exchange effects.

A weaker yen is a key part of Abe's growth package, as it should both stimulate exports and, by making imports more expensive, help to end the debilitating deflation. But Andrew Bell, manager of Witan investment trust, questions how long rivals such as Korea and China will be prepared to tolerate a falling yen before they, too, embark on competitive devaluations.

But he points out that, despite a rise of more than 80% in the Nikkei index over the past two years, the stockmarket remains relatively attractively valued, as these rises have mainly been accompanied by an increase in corporate earnings so that earnings multiples remain relatively unchanged.

Paul Chesson, head of Japanese equities at Invesco Perpetual, agrees that the corporate outlook is good. "Despite the difficult domestic backdrop, data from Mitsubishi UFJ Morgan Stanley shows that sales grew by 5% and recurring profits by 11.2% - excluding financial companies - in the six months to October, and that in aggregate companies had reached almost 52% of their full-year profit forecasts.

"With the central bank and the government both focused on supporting growth in the economy and our expectation that corporate earnings will prove to be resilient, we remain positive in our outlook on the Japanese equity market."

Passive routes into Japan 

As well as some of our favoured actively managed funds and trusts, which we outline in our Rated Funds sections, you can find a few cheaper passive versions below.

For Japan, the best strategy is to choose an ETF that tracks the whole market, ideally with a currency hedge.

Vanguard FTSE Japan (VJPN) has an OCF of 0.19% and has fallen by 0.3% over the year to 21 November, but the hedged iShares MSCI Japan GBP Hedged ETF, with a higher OCF of 0.64%, produced a return of 12.7% over the year.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.