Usually politics are irrelevant to the Japanese market as companies have long since given up any hope of clear political leadership and a concerted Government effort to end deflation. This time it is different. Abe's victory in the Upper House elections in July strengthened his coalition and, for the first time in seven prime ministers, he is likely to hold power for a meaningful period of time. His first and second arrows (ultra-loose monetary policy and flexible fiscal policy) are in place and have already had a positive impact.
The third arrow is the all important one and any delay in the implementation of its reforms may be seen as a sign of weakness. In 2014, new labour reforms in particular will be necessary. But for once the appalling demographics in Japan should be of some help in the short-term. Baby boomers are now retiring so a smaller labour force should help ease wage deflation.
In addition, while the planned consumption tax rise in April will go ahead, in order to offset the negative impact of higher VAT, a supplementary budget has been announced to support further investment and boost wages. This should help maintain the economic momentum.
All this is not going to be easy or happen overnight. Imagine this: a Japanese person who started their career in the 1990s, now in their forties, has never seen a bull market or inflation in their working lifetime.
An entire generation has become used to asset prices falling – why would you buy today when prices will be lower tomorrow? This is the enormity of the situation in Japan – it will take a long time for the habits of a generation to change: for Japanese investors to buy assets and for companies to believe things are changing for the better.
But Abe has given them hope and the latest consumer price inflation data of 0.9 per cent in October has hit its highest level in the 15 years since Japan slipped into deflation.
Due to continually falling prices for so many years, participation in the domestic equity market has been very low. It has also been shunned by international investors: just 1 per cent of UK retail investments are in the asset class, which is a dismal amount given it is still the world's third-largest economy.
But here as well, changes are afoot. The Nippon Individual Savings Accounts will be launched in January 2014. Similar to the UK ISA, it will allow individuals to invest $10,000 annually for five years, completely tax free. It is a temporary measure, but then again so was our ISA.
If it takes off, as hoped by many of the institutions backing it, it may well become a permanent feature. It certainly will not hurt in encouraging the Japanese to invest in equities again.
Japanese equities were my contrarian bet for 2013 and they remain my favoured developed market bet for 2014. Ruth Nash, manager of the JOHCM Japan fund, agrees.
"If, as we believe, this really is the start of a long-term bull market, large caps will perform well but the performance of small and mid cap stocks could be extraordinary," she said.
Performance of index in 2013
Source: FE Analytics
The market has enjoyed a 56 per cent rise in Yen terms – 26 per cent in sterling terms – since Abe won the election almost a year ago, so admittedly equities are looking less attractive on valuations. However, the market is still cheap versus its own long-term history.
I think the story still has a way to go and, as most UK investors are very underweight Japan, those who can afford to take the risk could consider topping up their allocation.
We have three Japanese equity funds on our Chelsea Selection buy-list: GLG Japan Core Alpha, JOHCM Japan and Jupiter Japan Income. I also like Legg Mason Japan Equity for small cap exposure.
Darius McDermott (pictured top of first page) is managing director of Chelsea Financial. The views expressed here are his own.
