Among concerns that growth rates may slow in US and Europe, Japan is expected to buck the trend and register 2.4% growth in 2006 according to a poll done by The Economist on a group of forecasters. The benchmark Nikkei 225 has registered average annual gains of 24% for the past 3 years compared to 12.8% in the S&P and 12.6% in FTSE. While the Japanese market was affected by the recent "Livedoor saga", which prompted retail panic and widespread profit taking activities, the market has since rebounded.

Reasons for continued strength in the Japanese market could be attributed to past years efforts of intensive corporate restructuring which resulted in drastically lower debt levels together with unproductive assets. Corporates are enjoying sharp improvement in profitability with margins at historical highs.

Forced unwinding of cross-shareholdings led by the government resulted in companies becoming more shareholder friendly and put strong focus on creating shareholder value. Traditionally, banks and corporate cross-shareholdings were as high as 15% and 30% respectively. But the landscape has changed with foreign investors accounting for about 25% (from 5% in 1991) and increasing rapidly. Individual investors account for about 22% while banks' cross holdings have decreased to about 5% and corporate to about 20%. Unproductive assets are either divested or restructured, while share buybacks and higher dividend payout programmes have been initiated as well.

Aided by a strong balance sheet and higher cashflow, corporates are in a better position to invest in capital expenditure. Machine order growth has continued into its 4th year due to strong demand and there are no worries of over-investing as companies continue to scrap old facilities and invest in new ones. Capacity utilisation remains high and has been improving for the past 4 years.

Improving corporate profits has contributed to reducing bad loans in Japanese banks. From historical highs non-performing loan (NPL) such as 24% and 28% in 1997 and 2001, the figure has dropped significantly to about 2.4% currently. Such a vast improvement means banks are more willing to lend and this is good news not only for corporate Japan but for the Asia region as well. According to BIS and SCB Global Research, Japanese banks used to account for over 60% of total foreign bank lending in China and Thailand, and over 50% in Hong Kong, Singapore, Indonesia, and Malaysia. To date, they account for less than 20% of foreign bank lending in these markets. Hence, there are vast opportunities for Japanese banks to leverage on Asia to grow.

Due to higher profitability, employment conditions have improved rapidly as well. The job to applicant ratio has moved close to 1.0 from 0.6 in early 2003 and average wages are finally up after 4 years of decline due to corporate restructuring. High wages meant more money in the hands of the consumer and recent data flow has suggested that consumption spending remains relatively strong in Japan.

With a decade of deflation, asset prices have fallen drastically but there are signs that Japan is moving out of deflation. An inflationary environment means that asset prices (such as houses and land) will rise and this is good news as it further improves the spending power of consumers.

In summary, the factors are in place for Japan to continue improving and deliver returns. And this time the growth is not powered by government spending, unlike in 1996 and 2000. Prime Minister Koizumi is pushing forward the largest spending cut in reform agenda by cutting the government workforce. Monetary policies are expected to remain loose as well to support further growth in the economy.

A key risk to the economy and the stock market comes from external factors like energy prices, which affect global demand. Rising US interest rates may slow the US economy and is negative for liquidity flow.