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Japan: Recovery from within

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The Nikkei looks set to end the year on a disappointing note and, even though ex-ports continue to dominate the best performing sectors of the stock market, Japan's economic recovery looks to set to occur from within as opposed to without.

We are going to see some kind of domestic-driven economic recovery rather than export-driven," says Yoshi Okable, head of global fixed income and currency at No-mura. "The export sector is still very important for the time being but the_recovery is gradually penetrating to domestic demand as the fi-nancial situation becomes healthier and healthier."

Susumu Kato, chief economist at BZW Securities in Ja-pan, agrees with this outlook, which he believes can only hold good things in store for equities. "The earnings gains for this year will be around 10%, so it should be favour-able for equity."

Investment in equities will be "steady", he thinks, which will help the market though Japan-watchers are not ex-pecting impressive rates of re-turn by year end. Okable ex-pects the index to move no higher than 20,200. "The important thing for Japanese equities is that the downside risk is extremely limited, not like last year's" he says, add-ing: "So that means we are probably underestimating prospects for the Japanese equity market as a whole, as there is not much left to attract foreign capital in."

Alex Kinmont, Japanese strategist at Morgan Stanley, cannot foresee any pick-up in the Nikkei index despite op-portunities to be had. "By the end of the year I think the market will be a bit lower than it is now," says Kinmont, predicting levels of "about 18,000 or 19,000."

He adds: "They are not go-ing to break out of the range they have occupied since the end of the bubble. Clearly there are opportunities to make money in Japan - certainly exporters, despite the fact that the index has done nothing."

Investors, though are "be-ing pushed to buy equities more than bonds," says Kato, due to low interest rates in Japan, and investors are starting to discount any rate hikes. However he is expecting some correction in the bond market: "The average for 10-year bonds this year may be 3-3.5% by year-end."

"The demand in supply balance is ludicrously skewed in favour of bonds," says Kinmont, "because the biggest buyer of bonds is the public sector through the trust fund bureau of the Ministry of Fi-nance which means there are very, very few bonds to be of-fered to pure private sector in-vestors at a time when pure private sector investors are in-creasingly worried about the strong economic forecasts which were put around earlier in the year. So you have an un-natural squeeze on the supply to pure private sector invest-ors. This is when you get ex-traordinarily low yields."

But Okable sees the bond situation as temporary, with rates having to rise by early next year after a market re-covery begins. "Once the market starts to recover there is no reason for Japan to maintain its extraordinary low interest rate policy," he says. " Sometime in the late half of this year and early part of next year, the Bank of Japan will have to raise overnight rates or discount rates."

Agreeing that the market has discounted this move he does not see a "marginally moderate" rate increase as a threat to the equity markets or long term interest rates. He predicts in the meantime, long term interest rates will "drift upwards maybe anoth-er 30-50 basis points".

In terms of best performing sectors, the unified opinion is that exporters will continue to do well, with Okable also taking a preference on blue chips and hi-tech firms.

On the domestic front however, despite the "relatively low quality" sectors, says Kinmont, there is room for improvement. "Medium to long r un, the fact is that most domestic companies in Japan are really quite poorly managed even now, so that the internationally diversified groups or domestic companies which are making an effort are the areas to be in." Rachel Oliver"

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