Is it time to give up on Japan?

Japan is often viewed as the one country where investors cannot afford to be underweight when its long-mooted recovery finally happens.

Bulls will argue that profitability remains far off peak levels and that corporate numbers have been impressive in the last few months but others fear that Japan's long awaited economic recovery is already running out of steam.

Nomura is one such group. It argues that it is high time to reduce Japanese equity weightings in favour of emerging market and selective Europe ex UK exposure.

Chief global and European strategist Ian Scott says the tentative Japanese recovery - which led Nomura to add to its Japan weighting in the last quarter of 2009 - could now be over, and contrasts its performance with strong growth in emerging market earnings and impressive second quarter results elsewhere.

The firm has reduced its Japanese equity market from an overweight 17% to a neutral 8%, while increasing emerging markets from an underweight 10%, to an overweight 16%.

At the same time Nomura's Europe ex UK exposure has ticked up from an already overweight 20% to 23%, chiefly on a belief that sovereign debt fears are overdone.

Despite Japan having been the best performing market in common currency terms this year, a combination of slowing earnings momentum, reduced GDP growth prospects, and a continued positive relationship between the yen and the relative performance of the Japanese stock market has led Nomura to reduce a pronounced overweight in the country to neutral.  

Scott says: ‘We had hoped that the recovery in profitability would at least display a similarly rapid trajectory on the way up as it did on the way down, but that does not now seem to be the case.'

He is also discouraged by the lack of firm results in terms of the pledge for a more radical monetary policy in Japan, despite policy makers insisting this would happen.  

He argues: 'With the yen currently trading at around 87 to the US dollar, and an expectation that it will decline to US$97 by year-end, the weakening in the currency will likely mean some common currency underperformance.'

While Nomura is retaining its year-end Topix forecast at 1,000 points, Scott notes that if the yen does weaken relative to other currencies, 'the common currency performance will be much less enticing, and simply in line with the global average.'

Meanwhile some of the assets from the reduced Japan weighting are finding their way into emerging markets and Europe ex UK equities, on a belief that  European markets have overreacted to the sovereign debt crisis.