![Japanese shares could extend their gains into 2017.](/content/dam/images/1/0/o/n/w/k/image.related.afrArticleLead.620x350.gtpi2k.png/1484221744025.jpg)
You may be surprised to hear that the best performing sharemarket in the developed world over the past six months is Japan's. And strategists reckon there's more where that came from in 2017.
The words "blockbuster growth" and "Japan" are rarely used together in the same sentence. After all, this is a country that has been mired in stagnation and borderline deflation since the bursting of its bubble in 1990. And indeed, the economy is likely to only grow by around 1 per cent over the year ahead.
But economic growth and sharemarket returns often bear little relation to each other. Just ask investors in Chinese equities over the past 10 years (or in Aussie equities for that matter).
So why are Japanese stocks expected to do so well in 2017? The story begins with the currency.
![The best performing sharemarket in the developed world over the past six months is Japan's.](/content/dam/images/g/t/q/5/2/8/image.imgtype.afrArticleInline.620x0.png/1484192198725.png)
The profitability of the country's export-heavy corporate sector is closely correlated to weakness in the yen. That means earnings – and share prices – typically receive a boost as the currency falls. And with the US-dollar exchange rate trading in a range of ¥115-¥118, up from ¥100 five months ago, "corporate Japan is in a sweet spot" says GaveKal Research analyst Neil Newman.
"The Japanese currency has weakened enough to give a handsome boost to corporate earnings in yen terms, but not enough to push the yen price of imported commodities up to painful levels," Newman writes.
That has helped spark the 23 per cent surge in the Japanese sharemarket over the past six months. "That strength is set to continue into 2017, with the Tokyo market remaining well bid on the back of a monetary policy stance that the Bank of Japan will find it hard – even impossible – to retreat from."
That monetary policy stance referred to by Newman is the commitment made by the BoJ, in September, to keep the yields on 10-year government bonds around zero. That has meant that even as global bond yields climbed at an alarming rate, Japan's government bonds, or JGBs, remained pinned at zero per cent.
"Against a backdrop of rising long rates elsewhere in the world, this policy trap has significant implications for flows out of the yen and into foreign currency asset markets, as well as for the Japanese equity and real estate markets," Newman writes. "These outflows have added to depreciation pressure on the yen."
With a weaker currency a stated policy goal, and with global growth and inflation picking up, the central bank looks to have timed its intervention perfectly.
"Retrospectively, there could not have been a better time for the BoJ to introduce its yield curve targeting approach," Morgan Stanley economists say.
Morgan Stanley's global strategy team in late November performed what it called a "double upgrade" of the Japanese sharemarket: from an underweight to overweight position. The strategists believe Japan, with Europe, will "lead the global earnings recovery" in 2017. But while European stocks will struggle to overcome the dampening impact of a variety of political risks over the coming months, they point to plenty of solid appetite for Japan's equity market, including from big government players such as the BoJ and the national pension fund, or GPIF.
"We believe that equity valuations can rise due to a combination of renewed re-engagement from foreign investors coupled with equity and ETF purchases from the GPIF and BoJ, respectively, that are equivalent to around 2 per cent of market capitalisation," they add.
Estimating that aggregate earnings per share in Japan will jump 24 per cent this year, Morgan Stanley forecasts a 16 per cent climb in the Topix index to 1800 points.
Citi strategists turned positive on Japanese shares not long after the US election in November, and for similar reasons: higher growth and a weaker yen is a mighty combination. They forecast the Topix index to end 2017 at 1650 points, implying a 7 per cent gain from here. That's a more modest return, but Japan remains their top equity market for 2017.
It's not just the exchange rate. The world economy certainly has built a head of steam, and Japanese businesses are firmly tied to the cyclical uplift. Global measures of manufacturing activity are well into expansion territory: PMIs have climbed steeply from around the middle of last year and ended 2016 at their highest in close to three years. The Citi global economic surprise index is showing an increasing number of data releases coming in ahead of expectations, pushing that measure to its loftiest since mid-2010.
Japan even looks well placed to withstand the anti-trade, anti-globalisation mood of the type championed by the incoming US president.
"About 14 per cent of Japanese company profits come directly from North American-based production and so should benefit from Donald Trump's promise to dramatically cut US corporation tax rates," Newman says. "Japan, which sells about 45 per cent of its offshore production in the US, is well placed to deal with a more 'de-globalised' world."
If that sounds convincing, the easiest way to play the Japanese theme is via the the currency-hedged Betashares WisdomTree Japan exchange-traded fund. The ETF tracks a "smart beta" fund, which applies some mechanical rules to put together a portfolio of the biggest Japanese listed names, and has an inbuilt tilt towards exporters. An alternative is the iShares MSCI Japan ETF, but a weaker yen will translate to lower Aussie dollar returns. Big names such as Platinum Asset Management also offer actively managed Japan sharemarket funds.
What about the risks? Well, a sharemarket that comes to be seen by offshore investors as primarily a currency bet does not make for a great long-term investment, and leaves your investment vulnerable to a sharp rebound in the yen. Analysts such as Citi's Naoki Iizuka, for example, would prefer to see more evidence of structural reform within the economy.
On the flipside, an ever-weaker yen could well spark criticism and perhaps even charges of currency manipulation from the likes of Trump, forcing some policy manoeuvres to reverse the trend.
Citi analysts see 125 yen per US dollar as something of a threshold in this scenario. The bear case would be some massive blow-up that threatens global growth and sparks a flight to the safehaven yen – a double whammy for the Japanese sharemarket. But then, that would be an ugly set-up for most shareholders.