Japanese equities, which have priced in a good deal of negative news, may benefit if the yen falls against major currencies and if the recent diplomatic confrontation with China over a group of small islands is quickly resolved, says Invesco Perpetual, the fund management house.

The yen has dropped around 10 per cent versus the dollar since when Japan’s elections were called last November (source: Financial Times). At  the start of this year, and this week, the Bank of Japan indefinitely pushed out its programme of buying up government bonds – or quantitative easing – and set a target of 2 per cent inflation, going beyond its previous 1 per cent goal. The move is seen as part of efforts by the country’s newly-elected government to overcome Japan’s decades-long deflationary period.

Summarising reasons for taking a cautiously positive view of Japan, Paul Chesson, head of Japanese equities at the fund house, listed several factors. To begin with, he said that the US and China, which together account for 42 per cent of Japan’s exports, are both recovering.

“The good news is that the US, which economically speaking is almost as important as China to the Japanese, has continued to recover, especially for key industries such as car manufacturing. With the housing market in the US beginning to show signs of revival, this is encouraging news for the outlook for 2013,” Chesson said.

“Toward the end of 2012 we thought China also started to show signs of bottoming. China and the US accounted for 42 per cent of Japan's exports in October, therefore we expect Japanese growth in 2013 to be no worse than 2012. This is an important conclusion, because we think that current share prices are implying a much gloomier outlook,” he said.

Islands dispute

Secondly, Chesson said the row between Japan and China about the Senkaku island chain in the East China Sea has hit investor sentiment, but the key issue is how long the dispute drags on. Previously, diplomatic disputes between the countries have been relatively brief, Chesson points out.

“China needs Japan's technology and inward investment, and Japan needs China's growing market for both consumer and capital goods, and services. The impact of those factors is intangible, but what is clearer is that so long as the Japanese make things the Chinese want to buy, they will buy them,” he said.

Turning to the currency issue, Chesson said the yen has been treated by investors as a “safe haven” amid greater global fears about the dollar and euro. However, with 10-year Japanese interest rates below 1 per cent last year, it is hard to see why the currency would attract investors.

“As we move through the economic healing process, especially in the US, and as the risk of ever-more aggressive monetary policy subsides, I believe investors will begin to hate the dollar a little less, and fall out of love with the yen a little more. The five-year high for the yen against the dollar was back in 2011, which suggests this is already happening,” he said.

He added that a weaker yen was not a “panacea” for Japan but may be the trigger to unlock value from Japanese firms.

Examining valuations of Japanese stocks, Chesson said that the country is “modestly cheap” by global standards, fetching a price-to-earnings ratio of 11.5 times 2013 earnings, below the global average of 12.9 times earnings. But that cheapness can be justified to some degree, given the country’s weak growth, low returns on capital and deflation.