There’s a growing school of thought that it is time to buy into the Nikkei. The argument goes something like this:

• Japan is practically the only country in the world that is benefiting from rising inflation – because it has extricated itself from a decade of deflation.
• Japan is one of the most energy-efficient countries in the world.
• Japan’s banks have had only limited exposure to the US subprime fallout, and do not need recapitalisations.
• Japanese equities are cheap.

While the above are true, I feel that the prospects for the Nikkei are not that bright in the short to medium term. Firstly, most Japanese indicators, ranging from consumer confidence to household expenditures, jobless data, construction starts, and the Tankan business survey are decidedly negative. Given that I remain bearish towards the US, I still see Japan as vulnerable to deteriorating external conditions.

Secondly, the political situation looms as a dark shadow over the Nikkei. Premier Yasuo Fukuda is likely to be forced out soon or call an early election, but if the LDP is returned to power with a reduced majority (it’s impossible for them to increase their majority, given the party’s unpopularity), the current political deadlock between the DPJ-controlled upper house and LDP-dominated lower house will be exacerbated. In other words, the prospects of reform would be diminished.

Perhaps the best hope for more business-friendly reforms lie with a DPJ victory in general elections, or the much-touted ‘Grand Realignment’ of political parties along ideological lines, with a new pro-deregulation, pro-market forces party forming the next government. However, both scenarios would involve a seismic shift in Japanese politics.

Bottom line: Both a sustained revival of the Nikkei and a dramatic political shake-up in Japan have been predicted for many years, and each time investors have been disappointed. Thus, I remain sceptical. However, just because something has not happened previously, that does not mean that it will never happen.