This difference between Tokyo and the rest of the world has historically been larger than in most other countries, meaning that a small investment in Japanese equities has lowered the total equity risk. The problem with this is that Japanese equities also need to give a positive expected future return. There are no doubt many causes of the underperformance so far this year, but increased political risk is probably the primary cause.
Inv
estor sentiment
Arguments to invest in Tokyo might seem difficult to find after 13 years of falling prices, low economic growth and political dead-lock. But there are many profitable companies. Analysts, who argue that now is a good time to invest long-term, point to improved cash flow in most Japanese companies thanks to many years of cost reductions. Lower share prices mean that the valuation (price/cash flow) is now much lower than in the US. When economic growth increases in Japan this gives hope for higher valuations.
At the same time there are persistent arguments against investing in Japanese funds. Deeply enbedded pessimism coupled with an aging population points to continued low growth. It also seems hard to find enough investors willing to commit new money, which would be needed to feed a sustained market rally, after being burned by previous downturns. Added to this is the continued risk that bad loans will give a financial crisis. The new leadership at the Bank of Japan is so far a disappointment, but waiting longer than a month for radical action to end deflation is reasonable.
Outlook
Political actions, especially economic reforms, are needed in Japan. An important event will therefore be the election in September of the party president inside the ruling LDP. The present prime minister Junichiro Koizumi has pushed for his reform agenda since being elected party president in the spring of 2001. Key questions are now if Mr Koizumi will remain firm on economic reform, and if he will win this LDP party election. If he is not re-elected president he will probably call a general election, with a very uncertain outcome.