JapanÆs equity market is nearing a turning point and is poised to produce strong returns, according to Schroder Investment Management.

Schroders notes that Japan is structurally under-owned by foreign investors, which is ôempirically a catalyst for future outperformanceö. Recent data suggests the domestic economy could be emerging from 18 years of deflation and price-to-earnings (P/E) ratios are now in line with other developed markets, the fund house adds.

ôUnloved and unwantedö is how Schroders describes sentiment for JapanÆs equity market over the past two-and-a-half years. Having enjoyed a 45% return in 2005, the Japanese market subsequently underperformed the MSCI World index by over 33% from end-2005 to end-2007.

That underperformance can be explained by the failure of the Japanese domestic economy to shake off the shackles of deflation and the consequent reliance on export growth at a time of global economic downturn and yen strength. Foreign investors û who represent 30% of the market and make up around 70% of market turnover (since January 2007) û have incrementally reduced their overweight exposure having moved structurally underweight in autumn 2007. This year, however, has seen a notable change in fortunes for the Japanese equity market, which has outperformed the MSCI All Country Asia ex-Japan index by over 8% year-to-date.

ôThe strong showing by Japanese equities possibly reflects the absence of the speculative inflows that characterised other Asian markets until the emergence of the sub-prime crisis in autumn 2007,ö Schroders says. ôThere was also a generally held view towards the end of 2007 that most of the bad news was already in the price. Valuations are certainly compelling.ö

Schroders notes that the price-to-book ratio for the market in aggregate is 1.4 times with in excess of 60% of the index constituents trading below book value. Perceptions are also beginning to change. Sell-side analysts have become increasingly positive over the past few months as the domestic economy starts to show signs of life. Unemployment remains low and wages are now rising at the fastest year-on-year rate for over 10 years. Inflationary pressures, which should bring with them positive stimulus, caused CPI to rise for the sixth consecutive month in March to 1.2% year-on-year. Exports remain strong despite a slowing US economy and companies remain cautiously optimistic in guiding to positive earnings growth for 2009.

ôDomestic investor buying has taken up the slack of foreign selling and the market is poised for an abrupt upturn, as it is often prone to do, once sentiment turns and foreigner investors close their structural underweight,ö Schroders says. ôAs sentiment improves further, and concerns over the macro background dissipate, we believe our investment approach should allow us to take full advantage.ö

Schroders is biased to attractively valued growth stocks that the fund house believes will prove to be beneficial as investors refocus on fundamentals such as earnings growth prospects and valuation.