We have written in previous research that the massive gains made in the Nikkei earlier this year would be subject to corrections investors would be in for a bumpy ride. Indeed, of the 80% gains made since the bottom in November 2012, the Nikkei has given back almost half (46%). But even after the brutal selloff, overbought conditions are still not unwound.
We still think the secular bullish case for Japanese equities is intact, but the key will be for Japanese policymakers to retain credibility. How? Since the BoJ has committed themselves to an inflation target of 2%, policymakers will likely have to be prepared to see inflation expectations overshoot and not back off the pedal. In this way, investors will gain conviction that entrenched inflation will be delivered. Note that this could be a multi-year process that will not occur in a straight line.
For now, it is unrealistic to expect more from monetary policy, but the Japanese government could show some leniency on the fiscal front. The OECD estimates that the fiscal drag will be 2.6% of GDP in 2014. Postponing the increase in the VAT tax scheduled for next year would be one way to reduce the drag and would send a strong signal to financial markets about the governments priorities.