s the Bank of Japan poised to raise interest rates? The Japanese government last week raised its forecast for the country's 2006 economic growth to 2.1 per cent, adding to expectations that interest rates could increase for the first time in six years. The uncertainty is already unnerving investors in the Japanese stock market, who had hoped the roller-coaster ride of recent years was at last coming to an end. During 2005 and early 2006, investment professionals tipped Japan as a hot opportunity, with the economy finally turning the corner after two decades in the doldrums. But since April this year, the Nikkei 225 index of leading Japanese shares has fallen 14 per cent.
Despite these setbacks, analysts argue that the picture remains sound. The recent quarterly Tankan survey from Japan's central bank shows local companies plan to increase their investment at the fastest pace in almost 16 years, which suggest a significant improvement in business confidence among Japan's biggest manufacturers.
Ed Gaunt, the head of Japanese equities at fund manager Threadneedle, says an increase from zero per cent interest rates would have symbolic importance because it would be an official recognition that an 18-year period of deflation has ended. Gaunt thinks a small interest rate increase of 0.1 to 0.25 per cent is likely.
"Any interest-rate increase would not necessarily be because inflation is considered to be too high, which is normally the case," Gaunt says. "Rather it is important because it would mean the normalisation of the interest rate and economic cycle in Japan, where there are already plenty of firm signs that the economy is recovering."
Following years in the doldrums, companies are now leaner than in the past. Consequently, corporate profits are increasing sharply. For instance, in the fiscal year ending March 2006, the net profits of businesses in Japan were 39 per cent stronger than in the previous year, Gaunt says.
The labour market is also in good shape. He says the jobs-to-applicants ratio is now 1.07, indicating there are more jobs on offer than applicants. This compares to 0.61 in August 2000. The stronger labour market is resulting in falling unemployment (currently at an eight-year low of four per cent) and rising wages. Ultimately, this is leading to higher spending and a boost in consumer sentiment.
Anja Balfour, the head of Japanese equities at Axa Framlington, is similarly positive. Although there have been plenty of false dawns in the past, she is confident that this recovery is different because it is being driven by the domestic rather than export sectors.
Although the Japanese stock market has fallen more than others elsewhere in the world since April, when the recent jitters took hold, Balfour says it was a case of investors taking profits after a strong rally.
"The Japanese stock market went up further than others, so when it came to taking profits, there was more money to be taken off the table," she says. "The fundamental picture for Japan has not changed and I'm still very positive that we are at the early stages of a sustained recovery." She expects the domestic economy will benefit from the demand that has been building up in the market after years of weak investment.
Balfour points out that capital expenditure in Japan has lagged the rest of the world, leading to a situation where the average age of machinery in Japan is around 12 years, compared to six in the United States.
"That has resulted in pent-up demand for investment in Japan," she adds. "There was a recent announcement that Honda was going to build its first new factory in Japan in 30 years. Komatsu is building its first new plant for 11 years and Nippon Steel is building the first new steel plant in the country for 20 years."
Justin Modray, an independent financial adviser at Bestinvest, says privatisation and industry deregulation will also drive the Japanese economy in the future, as "Thatcher-like" reforms shift economic influence from the public to private sector. However, he warns that Japan is not a one-way bet and there are plenty of reasons to be cautious. For instance, the high level of public debt, coupled with a shrinking population means that consumption tax (similar to the UK's VAT) is likely to rise during 2007/2008, and there are concerns this could slow consumer spending.
A shrinking population also means a shrinking labour force, which could impact corporate profitability in the longer term as wages rise. Furthermore, manufacturing remains an important sector for Japan. If the feared slowdown in global demand does materialise, this would be bad news for Japan's exports. Some also fear that the Bank of Japan will raise interest rates too quickly, which could impact on the profits of companies over the longer term.
Gaunt says that if interest rates do increase in the near future, the focus will then move to whether there will be subsequent hikes. He expects further increases to be very modest, with the Bank of Japan and Japanese politicians eager to avoid repeating the mistakes of 2000 when it tightened interest rates too quickly and derailed the recovery. He does not expect a modest increase to have a major impact on corporate profitability.
In fact, an increase could be a fillip for the stock market. The financial sector accounts for around 20 per cent of the Japanese stock market, and both Balfour and Gaunt expect the banks could benefit from being more profitable as a result of higher interest rates.
However, while Andrew Rose, the manager of the Schroder Tokyo fund, says the picture remains bright, most of the easy money has already been made, he thinks. He believes the period of strong overall earnings growthis now behind us. Therefore, companies will need to enhance shareholder value by other means, including the more efficient use of capital.
Paul Chesson, head of Japanese equities at Invesco Perpetual is even more cautious. His concern is events elsewhere in the world, particularly the US, where there are fears about growth and interest rates are rising.
Chesson says while all parts of the globe will be affected if there is a slow-down in growth, Japanese equities are more expensive than those in the rest of the world when considering their growth and earnings prospects. He is focusing on the defensive areas of the stock market, such as pharmaceuticals, railways and utilities.
The best funds for Japanese exposure
Investors with a moderate risk profile should have no more than five to 10 per cent of their portfolios invested in Japan, say independent financial advisers at Bestinvest and Chelsea Financial Services.
* Juliet Schooling, head of research at Chelsea, warns Japan is high-risk, so only invest if you are prepared for a bumpy ride.
* Justin Modray, an independent financial adviser at Bestinvest, says investors should consider funds that invest primarily in large companies.
"While this reduces the scope to benefit from increased domestic demand, it provides some insulation from the Japanese economy thanks to the globalised nature of these companies."
* Modray tips Martin Currie IF Japan and Schroder Tokyo, managed by Andrew Rose, as they are both run by experienced management teams.
* For higher-risk investors, JPM Japan, run by David Mitchinson, invests in smaller companies, which makes the fund more focused on domestic growth.
* For smaller companies exposure, Bestinvest recommends Legg Mason Japan Equity. Manager Hideo Shiozumi firmly believes in the structural change that is taking place. But this fund is very high risk so should only be held as a specialistholding, Modray says.
* Schooling also tips JPM Japan and Legg Mason Japan Equity funds as smaller-company focussed funds, along with recommending Axa Framlington Japan and Legal & General Japanese.