Japan - renaissance or false dawn?

Investors are getting excited about Japan again. Not for the first time since the Nikkei bubble burst in 1990 and the economy slid into recession, they see signs of a sustained recovery in the economy and hope that it will bring with it exceptional returns to Japanese equities. Are they right this time, or will Japan disappoint again?

There are certainly grounds for being optimistic. The economy is growing at only a moderate pace - but that reflects the "soft patch" in global economic activity. The composition of growth tells a different story. Consumer spending is reviving and business investment spending is expanding at a healthy pace. Companies appear to be spending money again - on capital and also on employment - rather than using profits to pay down their debts.

The most positive sign is rising full-time employment. In recent years, companies have preferred the flexibility offered by part-time workers and have steadily cut their full-time workforce. This is no longer the case. Full-time employment in Japan is now growing for the first time in a decade, and generally, boosts household incomes and spending. And the extra spending increases companies' revenues and allows them to recruit even more workers, giving a further upward twist to the economy. Vacancies are rising and new job offers are at a 15-year high. This, in our view, makes it more likely that the recovery will be sustained.

There is also evidence that Japan's deflation may be coming to an end. Consumer prices are still falling - despite higher oil prices. But wage inflation is picking up - a response to the improvement in the labour market. And land prices have stopped falling, as have house prices in the Tokyo area. There is a fair amount of spare capacity in the Japanese economy, so more general inflation may not be apparent until 2007, but things are at least now moving in the right direction.

The forthcoming general election can also be seen as a positive. Prime Minister Koizumi called for the election after his proposals for reform of the postal system were rejected in parliament. If he wins a clear victory in the general election, he will have a mandate for further structural reforms that will increase chances of a sustained recovery in Japan.

Of course there are risks. Koizumi may lose the election. The economic revival may not be sustained (there have been at least three false dawns in the last fifteen years). A major global slowdown could hold Japan back. But - whilst employment is increasing - the odds in favour a sustained recovery in Japan are better than at any time since 1990.

This should be good news for the equity market. A sustainable recovery will be associated with rising profits, which should attract overseas investors. More importantly, an end to deflation should cause domestic investors to drop their current ultra-cautious investment strategy and to switch from cash and bonds into equities. The Japanese equity market is not particularly cheap by international standards, but it certainly has scope to deliver strong returns on the back of sustainable profit growth. Overseas investors should also benefit from a rise in the yen as Japan becomes less reliant on exports for growth and the authorities feel comfortable about allowing it to appreciate.

In the financial markets, nothing is certain. But we are of the view that the economic outlook for Japan is better than it has been since the Nikkei bubble burst, which opens up the tantalising possibility of a buoyant equity market in the next few years.

Tony Dolphin, Director of Economics and Strategy, Henderson Global Investors