Japanese stocks: stick with the bulls

The Japanese stock market has suffered the worst drop of all major markets so far this year. But there's no need to panic.

Japan bulls are suffering from a nasty New Year hangover. After jumping by over 50% last year the Nikkei 225 has fallen by over 10% in 2014, the worst drop of all major markets. But there's no need to panic.

The Nikkei's fall is caused by global jitters: when risk-aversion rises, investors head for the yen, which is widely deemed a safe haven. A stronger yen is bad for the exporters who dominate the stock market.

But Japan's fundamentals are "more encouraging than anywhere else in the developed world", says John Authers in the FT. "Abenomics is working," adds Deutsche Bank.

The programme to end deflation and bolster growth after years of drift was named after the prime minister, Shinzo Abe, and consists of money printing, fiscal stimulus and structural reform.

GDP is expanding at an annual pace of almost 3%. Inflation has risen from -0.9% to 1.6% in the past year and earnings growth is climbing at its fastest annual pace in two years.

Along with a slide in unemployment to a seven-year low of 3.7%, this is fuelling hope that the recent rise in consumption will prove sustainable. Households bringing forward purchases before a consumption tax hike have flattered the recent strong figures.

An index tracking the manufacturing sector has risen to a cyclical high and there is now a "clear indication" of a rebound in capital expenditure, says Bank of America Merrill Lynch.

Machinery orders, a leading indicator of corporate investment, grew by 17% year-on-year in November. The gradually improving European and US economies should bolster exports.

The positive economic backdrop is delivering strong earnings growth. Since Abe was elected in December 2012, companies' earnings in the wider market have risen 123% in yen terms, says Authers, and 78% in dollar terms. Japan is also the only country where earnings momentum is positive: companies are revising forecasts up rather than down.

The Bank of Japan "remains keen to print money", which implies further yen weakness, especially since the US Federal Reserve is heading in the opposite direction.

Finally, valuations are still enticing. So while the mood of risk-aversion lingers, the stock market could continue to struggle. But the longer-term outlook remains compelling.

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