After hitting rock bottom the Nikkei is back on track.

With a massive change in sentiment towards Japan as an investment destination, global investors are suddenly sitting up and taking notice. The Nikkei 225 index has risen from under 9,000 to around 14,000 in less than nine months – a striking gain. No other mainstream stock market has performed anything like as well since Q4 2012.

After more than 20 years of grinding deflation, a new government under Prime Minister Shinzo Abe has been elected with a clear mandate to change direction. Despite many false dawns in the past, investors appear to have convinced themselves that the new reflationary policy could be the real deal.

The new strategy has three main elements – the ‘arrows’.

1. A commitment to use ultra-loose monetary policy and depreciation of the yen to drive the domestic inflation rate up to a new target of 2% per annum.

2. A huge 200 trillion yen programme of road building, infrastructure spending and other public works to help get the economy moving.

3. A promise to introduce a raft of ‘structural reforms’ to make the notoriously insular Japanese economy more competitive.

The past two decades have seen a series of failed policy initiatives to pull Japan out of its deflationary slump. One important difference this time round is that Mr Abe has won a decisive mandate for radical change in the elections for both houses of the Japanese Parliament. He also has the support of Japan’s powerful corporate elite. Like many other sectors of society, they seem to have realised that there must be radical change if Japan is to regain its footing as an economic and political force in the Pacific region.

A positive reaction

Not only has the Japanese stock market risen strongly, but the yen has fallen sharply in value. It is down by around 20% against the dollar since Mr Abe won the Japanese election. The new governor of the Bank of Japan, Haruhiko Kuroda, has also lost no time in unveiling his plans for hitting the new 2% inflation target within two years.

The plans include a huge programme of asset purchases. The Bank of Japan plans to buy as much as 70% of the new bonds issued every month by the Japanese Government.

The Japanese experiment

One of Mr Abe’s biggest tests will be to push through effective structural reforms against the opposition of vested interests, including the hugely influential and heavily protected farming industry.

Another enduring problem for Japan is the fact that the population is old and aging, a powerful headwind militating against higher economic growth. It may be, as some still argue, that Japan’s problems – poor demographics, falling productivity and mounds of debt – are simply too big for easy resolution. The fiscal stimulus programme will require more, not less debt, in the short term, so it is a high-risk strategy.

Is it too late to jump on the Japanese bandwagon?

Even after its 50% recent gain, the Nikkei index is still at little more than a third of the level it reached at its peak in 1989. If this really is a decisive change in the country’s fortunes, then there is still considerable upside potential for the best businesses. On most valuation measures, good Japanese companies still look cheap.

No equity market ever moves in a straight line, so there will undoubtedly be volatility, but on balance the outlook seems brighter than for many years – notwithstanding the real risk that the country will collapse under the weight of its accumulated debts before the reform programme has had a chance to prove its worth.

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