Japan’s rally has room to run

Japanese stocks may be 10% off their spring highs, but the rally's not over yet.

Between November 2012 and May 2013, Japanese stocks jumped by 75%. They are now 10% below their spring highs. But "Japan remains attractive as both a recovery story and a growth story", says Ed Rogers of Rogers Investment Advisors. The rally isn't over yet.

The main impetus behind the surge has been Abenomics, the government's concerted effort to end two decades of deflation and stagnation.

Part one of the plan is to print money in gargantuan quantities. The Bank of Japan's balance sheet is set to expand by 20% of GDP over the next two years as it injects money into the economy by hoovering up bonds with newly minted cash.

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The US Federal Reserve's balance sheet has only grown by 12% of GDP since it first began quantitative easing in 2008, notes Morgan Stanley. Abenomics also involves a fiscal boost and structural reforms to bolster the economy's long-term growth potential.

The slide in the yen resulting from all this money printing has raised corporate profits many major Japanese firms are exporters and lit a rocket under stock prices.

Higher asset prices, along with optimism fuelled by Abenomics and a cyclical recovery post-tsunami, has cheered up households and businesses.Employment growth is at its highest since 2007; retail sales and small business confidence are also at multi-year highs. GDP growth stands at 4% on an annualised basis. So why has the rally paused in recent weeks?

A key problem has been global jitters caused by the US fiscal stand-off. Declines in risk appetite buoy the yen, which is seen as a safe haven. So the end of the stand-off is good news.

And while risk aversion could flare up again, the big picture is that the US Fed is set to temper its money-printing programme next year, while its Japanese counterpart won't, says Capital Economics. This implies further yen weakness, as does Japan's vanishing current account surplus.

So profit growth should continue, especially since Japan Inc's operational leverage is so high, says Morgan Stanley. For every 1% in revenue growth, profits rise by 3%, compared to 1% in Europe and the US.

More detail on structural reforms, due in December, and reductions in corporation tax should also help. Stocks are also still cheap. The upshot? The Topix "could double" from here.