Japan’s bull market still has legs

734-tokyo-634 — Has Japan at last found the deflation exit?

Japanese stocks have had an excellent start to the year. The Nikkei has jumped to a new 15-year high above 19,437. In dollar terms, the Nikkei and the broader Topix index are the world's best-performing major equity markets so far this year, with a gain of around 10%. But the rally looks far from over.

For one thing, the latest data suggest that the economy continues to recover from last year's recession. Industrial production jumped by 3.7% month-on-month in January, while a sentiment survey covering all sectors of the economy has risen to an eight-month high.

Exports have risen and business investment, which has fallen for three quarters, should now turn around: capital goods shipments, a reliable indicator of capital expenditure, are back to a seven-year high.

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Lower energy prices and the tightening labour market have led to a rebound in consumer confidence. This month's spring wage negotiations between unions and large employers are crucial. The hope is that a healthy hike should spur more consumption and help start a virtuous circle of wage and price gains, thus ensuring an end to deflation.

Unions could win typical increases of 2.5%-3%, according to Daiwa's Kazuhiro Miyake the strongest gains since the 1990s. In which case, reckons Aaron Back inThe Wall Street Journal, the Bank of Japan "will likely be satisfied that Japan is well on its way to exiting deflation".

If it isn't satisfied, however, it will step up the pace of quantitative easing. Falling oil prices have reduced annual inflation to practically zero, and the bank will want to ensure that expectations of inflation start to become more entrenched after years of falling prices. The way to do this, and prevent expectations of flat activity and deflation returning and becoming self-fulfilling, is to get inflation back to the 2% target as fast as possible.

Yet more liquidity would be yet another tailwind (via a weaker currency and a further jolt to earnings) for a market that already looks compelling. As James Mackintosh points out in the FT, profits are currently expected to rise by 15% over the next year, more than in Europe, while in the UK and America they are heading in the opposite direction.

Domestic investors, notably pension funds, are back in the market, while corporate governance is showing signs of improvement. Throw in reasonable valuations, and it all adds up to a strong case to buy Japanese stocks.