The Japanese market performs relatively well when economic growth is respectable, especially when Japan is emerging from a bad market year. Last year was difficult for Japanese markets, as Japanese firms coped with a litany of natural and manmade disasters. The devastating earthquake and tsunami in March led to power shortages that hurt economic activity.

Consequently, expectations are low for Japanese corporate earnings growth. If the global economy puts in a reasonable performance as expected, Japanese stocks in well-positioned sectors should rise. Given the positive view of the inherent strength of the Chinese economy, the consensus is that world growth will at least reach 3 percent this year.

Investors are focused on the Japanese central bank’s increasingly accommodative policies. Politicians in this country are pushing the Bank of Japan (BoJ) to adopt a looser fiscal policy; as a result, inflation expectations have turned positive for the first time in five years. The central bank’s stated inflation target is one percent for the medium term.

Meanwhile, a segment of the political establishment is trying to put limits on the independence of the central bank. Proposals in Japan’s parliament, the Diet, would change current law to allow the government to play a role in the inflation target set by the BoJ. Proposed changes also call for government to exercise a greater say in the nomination of BoJ board members.

As the chart below depicts, inflation is again in positive territory in Japan, but only marginally.

Another important factor is the strength of the Japanese yen. As a rule, a weaker yen is better for the Japanese stock market. However, Japanese stocks sometimes have performed well even during yen strength, as has been the case this year. It’s more important to look at structural trends in the economy that could affect the market, rather than jumping on and off the cyclicality bandwagon.

The Japanese economy is in a state of fiscal expansion, as the government moves ahead with major reconstruction efforts in the Tohoku Prefecture, an underdeveloped and poor region. The government already has approved USD247 billion in reconstruction spending and is in the process in approving an additional USD42.5 billion. As a result, the Japanese economy is growing today faster than last year, and if this keeps up gross domestic product (GDP) growth should be above 1.5 percent in 2012.

Meanwhile, the average hourly wage has been rising in Japan, for the first time in more than a year (see chart below). A sustainable increase in wages will translate into more consumer spending, another big stimulus for the economy.

Source: Bloomberg

As Japan struggled economically for years, many investors didn’t bother to include Japan when strategically allocating funds. However, as the chart below indicates, foreign net buying of Japanese equities has turned positive again.

Source: Bloomberg

Even after its solid performance so far this year, the Japanese market remains one of the world’s cheapest. Although this distinction alone can’t take the market higher, it does offer relative support on the downside. The Tokyo stock price index, commonly known as TOPIX, trades at less than one times book value, while offering a 2.3 percent dividend yield

The major future risk for Japan is its budget deficit, which now stands at 9 percent of GDP. Net government debt-to-GDP is around 120 percent. Investors always have celebrated the fact that Japanese government debt is held domestically, but that’s gradually changing. True, more than 90 percent is still in Japanese hands, but ownership by foreigners jumped by two percent, to eight percent, in little more than a year.

This may not be the beginning of a new long-term trend, but the fact remains that foreign creditors usually demand higher yields when economic conditions sour. Investors should monitor developments in the Japanese government bond market (the second biggest in the world) for any indication of a sustainable increase in yields, especially because the government’s total financing needs for this year are equivalent to 60 percent of GDP, compared with 30 percent in the US.

Thrifty Fashionistas

Given that these negatives are far outweighed by the positive, investors should have some exposure in Japan.

The Global Investment Strategist’s Long-Term Portfolio has exposure to Japan via two holdings. The first is low-cost clothing retailer Fast Retailing (Japan: 9983, OTC: FRCOY).

The company is in 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; 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 (OTC: SVTMF), to open stores in the country.

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

Source: Bloomberg

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. As the chart directly above indicates, the stock has been gaining ground. It might take a pause for a while, but should be bought in the dips. Buy Fast Retailing up to JPY20,000.

The Bullish Case for Real Estate

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 Japanese stock market has yet to fully recognize these bullish factors, as the chart below shows.

Source: Bloomberg

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, with 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. 

According to the Organization for Economic Co-operation and Development (OECD), Japanese housing is the most attractively valued of all OECD countries, with the expectation that prices could rise 5 percent to 10 percent this year. A rise of this level would be good for real estate companies as well as the economy. 

The company recently sold an 18-year-old office building for USD794 million to Japan Real Estate, a real estate investment trust. Transactions of this magnitude also provide a stimulus to Japan’s real estate market. Mitsubishi Estate remains a buy up to JPY1,900.