In the Chinese Year of the Pig, will it be Japan that brings home the bacon for investors?

After a strong 2005, when hopes of rapid economic recovery saw the TOPIX index rise by 44%, 2006 was a major disappointment for investors in Japan. Pedestrian economic progress and a change in political leadership coloured the domestic news flow whilst the gradual exiting of speculative investors put persistent downward pressure on prices. John Kelly, Head of Client Investment at Abbey, looks at the current picture.

“2007 has started better,” says Kelly. “The main market indices have been pulled higher by a positive trend which has seen a four per cent gain in the past four weeks. It could well be that while China enjoys the year of the pig, it is Japan that brings home the bacon for investors.

“There are increased signs of economic success. In the final quarter of last year, the economy expanded at an annualised rate of 4.8 per cent, with corporate investment a key contributor. This reflects the improvement in business confidence in Japan, not just in current demand flows but also in their sustainability over the medium term. Demand is strong because of export success, which stems from the competitive advantages of a cheap yen and the progress Japan has enjoyed in establishing itself as a supplier of choice to China. Japan is the only non-commodity based major economy running a trade surplus with China, a position achieved by supplying the machinery which is allowing the industrialisation of China and by providing many of the higher technology components that go into Chinese exports.

“Growth for the full year will not maintain this rate of expansion but it will continue to build. And as domestic prosperity increases, so the chances increase that the component missing from this upswing - the consumer - will begin to contribute. Already we have seen signs of greater activity and with the job market tightening again – unemployment is down to four per cent - wage expansion cannot be too far away.

“What of the yen? The recent decision on interest rates will not on its own stem the weakness. But we should recognise that it is a weak currency held down by money flows despite a strengthening fundamental position. When those flows stop - or even slow down - then the effects of narrowing interest rate differentials, stronger growth or a strong trade surplus, will see upward pressure on the exchange rate. And when the reversal comes, it is likely to be dramatic.

“At the moment, it is the exporters which are leading the market, sensibly so given the trade picture. At some point this year, it will be right to switch into domestic issues as the relative momentum of the economy shifts. Overall, however, we expect further absolute and relative performance from Japan in the year ahead with the prospect that market returns will be boosted substantially by a recovering yen.“