Other macroeconomic uncertainties such as the tightening of monetary policy in China and the escalation of geopolitical tensions in the Korean peninsula have also preyed on investor sentiment. Against this backdrop, Japanese stocks have fallen alongside other major equity markets.

While the debt problems of certain peripheral European nations is a concern in terms of the impact on global financial markets, the eurozone itself accounts for only 11 per cent of Japanese exports and the so-called PIGS countries a mere 0.7 per cent. Furthermore, fiscal policy is likely to remain supportive in core members such as Germany and the outlook for overall demand in Europe continues to look firm.

Of greater concern is the effect of currency fluctuations on the competitiveness of Japanese exports, particularly in key sectors such as electronic equipment, materials and autos, and thus corporate earnings. At the same time, heightened political tension between the two Koreas has precipitated a plunge in the won, which poses further problems for Japanese manufacturers.

These doubts, alongside the other issues troubling investors, could see the yen appreciate further from here as it is widely regarded as a safe haven currency. The Bank of Japan has been easing monetary policy in an attempt to combat deflation, weaken the yen and therefore render Japanese exports more competitive. However, events elsewhere seem to have neutralised the effects of that policy for the time being.

A stronger yen may diminish investors’ confidence in the ability of Japanese companies to grow earnings in the near term. However, I think the wider global economy, propelled to a large extent by Asia, can continue to sustain a stable recovery regardless of the situation in Europe and that bodes well for corporate Japan. 

The recovery of global growth is being led by a rebound in world trade, corporate spending and general manufacturing activity and we are also starting to see that filter down to show signs of improvement in personal consumption in some areas of the world. Europe may be a major world market but the rebound in the economies of the Asia region, which now account for around 55 per cent of Japanese export trade, has been particularly pronounced and Japan continues to benefit from its exposure to fast-growing countries such as China. 

Furthermore, signs are emerging that the export-led production recovery has started to spread to non-manufacturing sectors, as noted by the governor of the Bank of Japan, Masaaki Shirakawa, at the central bank’s most recent policy meeting. A recovery in external demand, combined with massive fiscal and monetary stimulus, are gradually feeding through to capital expenditure, consumption and housing investment via a rebound in corporate earnings. Although the effects of policy stimulus, both in Japan and overseas, are expected to fade over time, improvements in employment and income conditions are likely to support household spending, which should maintain a moderate uptrend.

While an earnings recovery for fiscal 2010 has generally been discounted in current market valuations, I think there are some substantial positives for the corporate sector in Japan that could justify higher valuations. First, following the global financial crisis, the inventory rebuild and subsequent upturn in final demand creates significant potential for upward earnings revisions. In fiscal 2010, assuming both a continuation of the global recovery trend and the stabilisation of the yen exchange rate, we should see a sharp rebound in corporate profits.  Secondly, in many cases, aggressive cost cutting has left companies operationally geared into improving top-line growth. This could lead to some large earnings surprises as demand recovers.

While these factors should see Japanese firms deliver stronger-than-expected earnings growth, I believe those rates of growth will start to diverge. Differing rates of earnings growth are often overlooked in the early stages of recovery as all growth is welcomed by investors but, as we move into the later stages of the recovery, investors should be willing to pay a premium for stronger and more sustainable growth prospects.

In that environment, I see this year being all about bottom-up stock selection. That’s how the strongest returns will be made in Japan.