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Big in Japan

We turned bullish on Japanese equities in the second half of 2008 and we remain so today.

This is not based around positive expectations for the Japanese economy or for corporate profits but it is grounded in the fact that we believe many Japanese equities are simply too cheap.

While our expectations about the potential returns available from Japanese stocks changed last year, our view on the Japanese economy did not.

The pace of deterioration, particularly in the latter part of the year, underlined the significant challenges that currently prevail.

We fully recognise that things are bad and that they are likely to remain so for some time and almost any economic statistic released recently could be used to support this point.

Indeed, the Bank of Japan has recently downgraded its own forecasts for the economy in the fiscal years 2009 and 2010, further confirming the extent of the current challenges.

But we do not believe that this poor economic environment is necessarily a barrier to Japanese equities delivering robust returns.

While it may appear counter-intuitive, given our bullish stance on Japanese equities, we are also cautious on the outlook for corporate profits, even in respect of some of the stocks that we own. The reason we are optimistic about investing in Japan at this time is that we believe the stocks in our portfolio already discount a far worse deterioration in profits than is likely to occur.

At current levels, the likes of Honda, Murata Manufacturing and Tokyo Electron are cheaper than we have ever seen them. In our view, these are high quality companies with globally recognised franchises and the potential to deliver robust earnings over the long term, which are pricing in not just recessionary conditions but a depression.

Improvement in the operating environment for these kinds of export- oriented groups will be closely linked to the US, which we believe will come out of recession before Japan.

The US was one of the first economies to suffer meaningful contraction and was also one of the earliest to start implementing expansionary measures to counter the downturn. Stabilisation and improvement in the US will obviously be positive for the global economy but it will be particularly important for Japan, which cannot recover fully without an upturn in export demand.

A stronger US economy would clearly be a major catalyst for the blue-chip exporters that we are significantly overweight in and whose valuations we believe are so compelling.

US recovery could also see interest rates in the world’s biggest economy normalise, supporting the dollar and putting pressure on the yen. A weaker currency would provide a further significant boost to Japanese export groups, just as yen strength was a powerful headwind that compounded the economic slump in 2008.

In contrast, we are still avoiding industrial cyclicals and commodities, specifically areas such as steel, chemicals, shipping and machine tools. While in absolute terms valuations are low in these sectors, we do not find prices attractive enough and we expect earnings to remain under pressure for longer than for car makers and electronics groups.

We also have no exposure to defensive sectors. These areas of the market performed well for us last year but as financial market turmoil intensified and greater volumes of money flowed into these companies, their valuations became increasingly inflated.

We believe that these sectors are not only expensive relative to the wider market but they have little genuine growth potential and this leaves them vulnerable to substantial underperformance in a more positive market environment.

Paul Chesson is manager of the Invesco Perpetual Japan fund

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