×

Japan elections a wild card for Nikkei

Yoshikazu Tsuno | AFP | Getty Images

Japanese stocks are hovering at fresh seven-year highs as investors ignored a sovereign debt ratings downgrade by Moody's to focus on a slumping yen, but analysts say further upside could be limited as markets gear up for the national elections in two weeks.

According to Kenji Shiomura, Daiwa's senior equity strategist, a poor attendance by voters could knock the wind out of Nikkei's rally as investors see it as a sign that voters aren't backing Prime Minister Shinzo Abe's economic policies.

"I don't see any major upside - turnout is expected to be at a historical low, and the markets will take that as a sign that voters aren't convinced about Abe's economic policies," said Kenji Shiomura, Daiwa's senior equity strategist. Still, Shiomura is forecasting the Nikkei will end the year at around 18,500.

Read MoreWill snap elections derail Abenomics?

After a ho-hum performance for much of this year, the Nikkei caught fresh momentum after the Bank of Japan in October shocked markets by expanding its already massive asset-buying program for the first time since it was rolled out in April last year. The Nikkei surged 12 percent since and traded at 17,772 on Wednesday, as the yen crumbled nearly 9 percent against the U.S. dollar.

Even a Moody's downgrade of Japan's credit rating this week, by one notch to A1 from Aa3, didn't deter the rally.

Abe called the snap election scheduled for December 14 last month after data showed the country falling into recession, with its economy shrinking an annualized 1.6 percent in the third quarter, following the second-quarter's 7.3 percent contraction.

Voters uninterested

While the consensus view is that Abe would sweep an election victory, more worrying for markets, analysts note, is that voters don't seem to care.

In the latest weekend poll by Kyodo news agency, 41.2 percent said they haven't decided which party to support. That opinion poll put support for Abe's ruling Liberal Democratic Party at 28.0 percent, up 2.7 percentage points from the previous poll carried out from over the weekend of November 19 to 20. Only 10.3 percent said they will vote for the largest opposition group, the Democratic Party of Japan.

Read MoreJapan's yen is about to get pummeled-even more

So the issue isn't whether the ruling LDP will be returned to power, but by what margin. And that could easily change the direction of stock markets in the near term, market watchers say.

Potential upside

"There is some upside [for stocks], depending on the election results. If the ruling Liberal Democratic Party does not lose any seats, the Nikkei could rise to 19,000 by the end of this year," said Hisao Matsumura, Nomura's senior equity strategist. Based on fundamentals however, he sees the Nikkei moving in the 17,000 to 18,000 range to the end of December.

Read MoreNew repair manualneeded for Japan's economy

Beyond politics, there is also the question of whether the market is running ahead of itself.

"There is some concern about stock prices overheating," said Tsuyoshi Ueno, senior economist at the NIL Research Institute, who sees the Nikkei staying at around 17,500 until the year-end.

"The wild card is where the dollar-yen trades," says Ueno. "The pair has been so volatile of late that it's difficult to forecast. If the yen goes below 120 against the dollar, I can see the Nikkei ending the year at around 18,000."