While there are still concerns about the fading effect of yen weakness last year and slower demand due to the consumption tax hike from 1 April, we remain positive on Japan’s longer term structural trends, namely an exit from deflation, a tightening labour market and recovering levels of corporate spending.

A key gauge of the country’s inflationary success- core Consumer Price Inflation (CPI) - was up 1.3% year-on-year in February. More importantly, February core-core CPI - which excludes food and energy - showed a 0.8% increase and grew at its fastest pace in a decade. This measure, which also excludes any impact from rising fuel prices, has often been considered an important indicator of whether the Bank of Japan (BoJ) can reach its 2% inflation target. Meanwhile, employment data showed that Japan’s jobless rate fell to a six-year low of 3.6% in February. Tightening of the labour market should provide upward pressure to wage growth which we expect to support the inflationary environment in Japan.

These data releases come ahead of next week’s 1 April tax hike that will see sales tax rise 3% from the current 5% to 8%. While this has dominated news headlines and induced a sell-off in the equity market on concerns about the impact on corporate earnings in the April-to-June quarter, we feel these fears have already been priced-in to a certain extent. Consumption is likely to slow in the April-to-June quarter but we believe it will be a short-term disruption and the market may have overreacted. The longer term positive structural trends of an exit from deflation, a tightening labour market and recovering levels of corporate spending all remain on track.

On the back of this we expect corporate earnings to remain solid overall, despite the initial setback following the tax hike, which could last one or two quarters. We expect full-year earnings to continue to grow. The TOPIX is trading on a price-earnings ratio of around 13 times full-year 2014 earnings, and is looking reasonably cheap from both a historical and global perspective. Furthermore, the BoJ will probably spring into action if weaker-than-expected economic data comes through and there is any threat to their optimistic scenario of 2% inflation. In addition, there could be further positive developments regarding Prime Minister Abe’s growth strategy, including free trade zone discussion and corporate tax reforms.

Regarding our approach, we remain focused on stock specific ideas based on fundamentals and remain well-positioned to capture any upside of the earnings recovery and positive developments in the Japanese economy.