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A pedestrian walks past an electronic board displaying the Nikkei's movements outside a brokerage in Tokyo October 25, 2013.YUYA SHINO/Reuters

If seesawing stocks are making you wonder about the future direction of the S&P 500, spare a thought for Japan's Nikkei 225: It's the worst among developed market indexes this year after slumping 10 per cent; yet it is among the best since the start of 2013 with a gain of 40 per cent.

In other words, it's absurdly high and worryingly low at the same time. But Julian Jessop at Capital Economics offers a few points on why Japanese stocks should be able to shake off the uncertainty with a rally to 17,000 by the end of the year. If he's right, his target implies a gain of more than 16 per cent.

The recent setback, he noted, has coincided with a rise in the value of the yen, which weighs on Japanese exports. More broadly, though, Mr. Jessop argues that foreign investors have been losing confidence in Japan's economic reforms, dubbed Abenomics after the country's prime minister, Shinzo Abe. They may now be more focused on the downside risk to one element of these reforms, the hike in consumption taxes to 8 per cent from just 5 per cent.

The economy certainly looks fragile. In the fourth quarter of 2013, Japan's gross domestic product expanded by just 0.7 per cent, below an initial estimate of 1 per cent and lower than the 0.9 per cent growth in the third quarter.

On Tuesday, the International Monetary Fund lowered its forecast for global economic growth in 2014, to 3.6 per cent from 3.7 per cent previously, partly because of Japan. The IMF now estimates the Japanese economy will grow 1.4 per cent this year, down from an earlier estimate of 1.7 per cent, with a one-in-five chance of slipping into recession.

Mr. Jessop believes concerns will continue to weigh on Japanese stocks in the months ahead. But he sees three reasons to stay bullish:

1. Bond yield differentials
U.S. bond yields are headed higher this year. Capital Economics believes the yield on the 10-year U.S. Treasury bond will rise to 3.25 per cent by the end of 2014, up from nearly 2.7 per cent now. That should drive down the value of the yen against the U.S. dollar, which is good for Japanese corporate profits.

2. A rebound in third quarter GDP
Japanese economic growth in the second quarter is a big question mark, with contraction a definite possibility. But Mr. Jessop said that it has to be weighed against a likely surge in the first quarter and a probable rebound in the third quarter. "In the meantime, possible equity-friendly developments in the summer include the restarting of nuclear power stations and the announcement of meaningful cuts in corporate taxes," he said in a note.

3. More stimulus from the Bank of Japan
Mr. Jessop expects the central bank to extend its asset purchases – akin to the stimulus used by the Federal Reserve with its quantitative easing program, now winding down – throughout 2015. Expect an announcement in October.

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