Hold your nerve on Japan

Japan's stock market soared 50% last year.

2014, however, has got off to a disappointing start. Japan's Topix index is down 9% since New Year.

The rising yen is worrying investors. There's also concern that emerging markets instability will spill over into Japan.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

But I'm not hugely worried. I still think the Japanese stock market will deliver attractive returns over the medium term. It's time to hold your nerve.

Deflation

When you have deflation, things are tough for anyone with debt. If prices fall 2%, banks don't suddenly reduce the size of your debt by 2%, so the real' value of your debt goes up. As a result, many businesses and individuals draw in their horns and spend less. And that doesn't help the economy to grow.

That said, deflation isn't all bad. Many consumers are delighted to see lower prices at the shops. So in the early years of deflation, your average Japanese voter didn't see the phenomenon as a problem.

However, one Japanese fund manager, BNY Mellon's Miyuki Kashima, tells me that's changed. Voters now associate deflation with low growth and Japan's longstanding economic malaise. So they're now prepared to support an aggressive plan to end deflation, and that's what Japanese prime minister Shinzo Abe is implementing.

Working with the Bank of Japan, Abe has been aggressively printing huge amounts of money, and using it to buy government bonds this is known as QE (quantitative easing). So far, Japanese QE has been focused on buying government bonds, but Kashima thinks that it may widen out and include the purchase of other assets in future.

Some sceptics argue that such an aggressive money-printing programme will lead to trouble in the long term. The creation of so much money could eventually lead to high inflation and it might also create an unsustainable debt bubble, according to the sceptics.

Now, I don't share this view, I think the Japanese economy is in such a deflationary slough, I can't see it going too far the other way. But even if I'm wrong, QE will surely lead to higher share prices before higher inflation comes later. That's certainly what has happened so far with QE in the US and UK, regardless of any recent market wobbles.

So, whatever your view on the rights and wrongs of QE, I still think an investment in Japan makes sense.

More reasons for optimism

Abe is also pushing through structural changes which should increase the economy's growth potential. For example, he's determined to get more women into the workforce, and also to ensure that women already in the workforce are able to reach their full potential.

Kashima told me that it's extremely hard for Japanese women to get any kind of daycare provision, but Abe has now pledged to create 400,000 daycare places.

Another fund manager, Hideo Shiozumi, expects Abe to announce further structural reforms this June. Interestingly, Shiozumi thinks these reforms mean that the Japanese stock market's best performance may come in 2016.

I'm not going to make such a precise prediction, but I share Shiozumi's view that further structural reform will come and that it can only be a good thing for investors.

I'm also pleased that corporation tax will be cut by 2.4% in April. That cut will coincide with an increase in sales tax. Hopefully the corporation tax cut will offset any negative economic impact from the sales tax hike.

Returns on equity

return on equity

a new stock market index

Hopefully, this index won't just persuade companies to make the best use of their capital, it may also prompt Japanese pension funds to invest more heavily in the Japanese stock market. At the moment, most Japanese pension funds have a surprisingly low exposure to their home country.

Short term

But I remain confident that Japan can probably ride out these problems and be a decent investment for the medium term. Probably for the long term too.

If you want to invest in Japan, I've previously recommended the Lyxor Japan ETF as a cheap way to get some Japanese exposure the charge is 0.45% a year. If you'd rather invest in an actively managed fund, take a look at the Baillie Gifford Japan investment trust, which has performed well over most time periods. I've invested in both funds myself.

Our recommended articles for today

Fracking: Nine reasons not to get carried away

QE can never end and Janet Yellen knows it