Why you should invest in Japan

Last year it seemed that Japans sun was finally rising again.

The Nikkei 225 ended 2005 at 16,111, up 40% on the year.

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And then came the sticky problem of US interest rates. The fear that higher rates will force Americans - the world's most important consumer group - to stop spending was one of the factors behind the global stock market slump in May and June.

Japan was one of the biggest sufferers as foreign investors, who fuelled most of the stock market rise in the first place, pulled their money out of the country. The Nikkei 225 fell as low as 14,218 and is still around 10% below the near-six-year high of 17,563 it set in April.

So is this just another false dawn for Japan? And even if it isn't, is Japan really capable of withstanding a US slowdown?

Investing in Japan: not just a false dawn

In short, no - it's not a false dawn; and yes - of all the world stock markets, Japan is probably best-placed to cope with a slowdown in the global economy.

I can't say for sure that the Japanese market won't fall again in the coming months if I could, I wouldnt have to work for a living. But there are plenty of strong reasons to invest in Japan and if anything, economic data since the May slump has been getting stronger.

Business is booming. Large manufacturers are operating at near-full capacity. And yet economic forecasters are consistently underestimating the speed of the recovery. In April, machinery orders were expected to grow by 3.5% - the actual figure was 10.8%.

Office space in Tokyo is also near-full. Vacancy rates are at their lowest for five years, and property and land prices are rising again.

All that new office space and equipment means firms also need more staff. The latest Tankan business survey showed that companies of all sizes expect the labour market to tighten further in the next three months. That means wages will also be driven higher which is good news for consumer spending.

Investing in Japan: don't fret about exports

It's true that if US consumers reins in their spending in the face of rising interest rates and a cooling housing market, that will make life tougher for exporters. However, it's important to remember that net exports only account for 12% of Japan's economic growth - its by no means the be-all and end-all of the Japanese recovery.

Exporters will also have to come to terms with a stronger yen, which will make it harder for companies like electronics giant Sony and carmaker Toyota to compete abroad.

But these are huge multinationals with factories and employees in countries across the world. If a slump in US sales forces Honda to cut back on jobs and shut down factories, where do you think those closures will take place? In Tokyo or the Midwest?

And as one manager at Bedlam Asset Management points out, if exports are so important to Japan, then why has its economy been in the doldrums for so long at a time when the rest of the world economy was booming?

The fund management group says: "Japan's domestic recovery remains a clear and simple story. Improving job prospects and wages are stoking domestic consumption and credit growth, which combined with rising business confidence and investment, has allowed the economy to emerge from deflation."

Bedlam expects to see 'dramatic' upward revisions to earnings forecasts when companies start to report their first-half results in September.

Investing in Japan: interest rates

What about Japanese interest rates? Investors are looking nervously on as the Bank of Japan prepares to hike rates from zero percent to 0.25%, perhaps as early as this month.

But there's no need to worry. The fact that Japan is ready for higher interest rates is a good sign. Although the end of Japan's easy money' might be hard on foreign investors who have borrowed in yen to invest in currencies with high interest rates, such as the Icelandic krona, it's by no means bad news for Japan's domestic economy.

Demand for bank loans rose at an annual rate of 1.2% in April the best growth in 10 years. Although interest rates have been sitting at zero, Japan's banks have only been willing to lend to large companies because their balance sheets have been weakened by bad debts from the previous credit bubble collapse.

But as bad debts have been cleared and balance sheets repaired, the banks feel more able to take bigger risks and that means it becomes easier for the man or woman in the street to take out a personal loan or a mortgage.

Investing in Japan: good news for banks

So when interest rates finally rise, that's good news for profits in the banking sector.

Why? Because Japanese banks are the same as banks the world over.

When interest rates rise, it's the perfect excuse for them to charge more for loans. But at the same time, the rates of interest they pay on savings accounts don't budge. That increases their profit margins which in turn enables them to dish out more loans.

With credit conditions easing, wages rising and unemployment falling, there's plenty of scope for Japan's consumer spending to keep rising. And importantly for the stock market, domestic investment also has plenty of room to improve.

Domestic institutions and individual investors are still just about net sellers of Japanese stocks - but that's likely to change later this year, as the economic and corporate data just keeps improving.

And when domestic investors start to believe the recovery story, Japanese stocks will really take off.

Smart investors would be advised to get in before the rush.

First published on MSN