Last year was difficult for Japanese markets as Japanese firms had to cope with a litany of natural and manmade disasters. The devastating earthquake and tsunami in March led to power shortages that hurt economic activity. The yen’s appreciation and the EU’s sovereign-debt crisis affected demand for the country’s exports. Flooding in Thailand hurt production for Japanese technology companies. Japan’s economy continues to face headwinds; we forecast 2 percent gross domestic product (GDP) growth from Japan in 2012.

Consequently, the bar has been set relatively low in regards to earnings growth for Japanese companies, and a decent performance by the global economy should result in double-digit growth in 2012. Unfortunately, this outcome is unlikely to materialize until the second half of the year.  

That being said, the Japanese market remains one of the world’s cheapest markets. Although this distinction alone cannot take the market higher, it does offer relative support on the downside–the Nikkei 225 index trades at only 15 percent above its 2009 low. 

Japan’s economy remains in the grip of deflation, although we believe the market has discounted this fact for some time.  The TOPIX index yields more than the 10-year government bond and trades at 0.9 times book value, compared to a long-term average of 1.7 times book value. The index’s valuation is now at a similar level as its low during the 2008 financial crisis.

The stronger yen has been another issue for Japanese companies. A strong yen has traditionally been seen as a negative development for Japanese companies. But their stock performance demonstrates that investors are less concerned about the strength of the currency; Japanese stocks have performed well even during periods when the yen appreciates.  

Nevertheless, foreign investors benefit from a rising yen. For example, shares of Portfolio holding Fast Retailing (Japan: 9983, OTC: FRCOY) gained almost 10 percent in 2011. But that the return was even higher in dollar terms–16.5 percent.

The yen was strong in 2011 and we believe the currency will maintain this strength in 2012 because it remains undervalued against the greenback in real terms. As the chart below shows, prior to the current rally, the yen’s longest upward climb occurred from the second quarter of 1990 to the spring of 1995.

The current rise of the yen began in 2007, and if history is any guide, then the Japanese currency should remain relatively strong until the summer.

Source: Bloomberg

The Japanese economy faces a number of domestic and international challenges in 2012. Nevertheless, massive government spending to rebuild infrastructure after the March 2011 Tohoku earthquake should continue. The government already has approved USD247 billion in reconstruction spending and is in the process in approving an additional USD42.5 billion. This initiative should be a positive for the economy, particularly in light of an uncertain outlook for the global economy.

This same uncertainty means that the Japanese stock market should trade in a range for the first half of the year, or until a clearer picture emerges from Europe or the US.

After that, Japan should be able to gain some ground, particularly if emerging-market demand for Japanese exports remains strong. In other words, expect Japan to be a beneficiary of any  recovery in the global economy.

The Global Investment Strategist’s Long-Term Portfolio has exposure to Japan via two holdings. The first is low-cost clothing retailer Fast Retailing. The company is on the forefront of a global trend toward “thrifty fashion.” It has built its reputation on sales in its home market of Japan, which still accounts for the vast majority of revenue. However, overseas sales are growing rapidly as the company pushes into both developed and emerging markets.

Fast Retailing has focused its expansion efforts on Asia and the company expects overseas sales to more than double domestic sales by 2015. Additionally, the company recently said it would form a venture with the Philippines’ largest listed retailer, SM Investments Corp, to open stores in the country.

The company aims to be the world’s largest clothing retailer by 2020 and to boost sales sixfold to JPY5 trillion (USD65 billion). Overseas growth in both developed and emerging markets such as China will be critical to achieving this goal.

Fast Retailing continues to adjust its strategy in a cutthroat retail environment. However, the company has proved that it can respond with agility to changing market conditions and its global expansion continues apace. Buy Fast Retailing up to JPY20,000.

Mitsubishi Estate (Japan: 8802, OTC: MITEY) is the Portfolio’s second Japanese holding. The company is one of the country’s most prestigious real estate companies, with land in some of the most coveted office areas in Tokyo. Mitsubishi Estate also boasts an active residential business and runs six hotels in Japan.

Japan’s real estate market remains well positioned for growth. Office prices have continued to climb even after the earthquake, condo prices are firm, and developers can raise funds at low interest rates. The stock market has yet to fully recognize these facts.

Mitsubishi Estate’s newest luxury condo development, Parkhouse Harumi Towers Krono Residence, has attracted strong sales interest. Property sales are slated to begin later in the month, and Mitsubishi Estate is bullish on unit sales based on indications of strong demand.

The property is the first part of a two-tower, 1,800 unit complex. This is the first building in Tokyo to win the most stringent seismic certification, and the building features disaster prevention storehouses on each residential floor. The safety and the superior views provided by its coastal location have driven demand from affluent Tokyo residents.  

The company recently sold an 18-year-old office building for USD794 million to Japan Real Estate, a real estate investment trust. Transactions such as that, should they continue, will stimulate Japan’s real estate market. Mitsubishi Estate remains a buy up to JPY1,900.