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Is a massive rebound coming for the Nikkei?

Yoshikazu Tsuno | AFP | Getty Images

After a blow-out 2013, Japan's stock market seems to have lost its luster, but according to global research house Capital Economics the Nikkei is set for a dramatic turnaround.

"The prospect of renewed outperformance in the Nikkei is good, especially with the possibility of further aggressive stimulus," Julian Jessop, chief economist at Capital Economics said at the company's annual conference in Singapore on Wednesday.

Capital Economics sees the Nikkei rallying 20 percent from its current level of around 14,093 to 17,000 by fiscal year end in March 2015. It expects the index to reach 18,500 by March 2016.

Read MoreKuroda: Impact of Japan tax hike will be contained

This would mark a dramatic turnaround for the Nikkei which has fallen 13.2 percent year to date, giving up a large chunk of last year's 55 percent rise.

Concerns over the impact of a consumption tax hike in April coupled with uncertainty over Japan's structural reforms led some investors to lose faith in Abenomics - the aggressive plan unveiled by Prime Minister Shinzo Abe in 2013 to revitalize the economy through monetary stimulus, fiscal spending and structural reform.

Capital Economics shares these concerns, but believes further aggressive monetary stimulus from the Bank of Japan (BOJ) will reinvigorate the country's stock market, propelling it higher over the coming years.

"Monetary stimulus should indeed be a key driver, as it should push the yen lower and boost the yen-value of overseas earnings," said Marcel Thielant, Japan economist at Capital Economics. He expects the yen to decline to 120 per dollar by year end from around 101.5 currently.

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Thieliant added that the BOJ's inflation target of 2 percent was too optimistic. Once the BOJ realizes he expects the central bank will be compelled to ease further to boost inflation levels.

The BOJ expects the core consumer price index to rise 1.3 percent for fiscal 2014/2015 and 1.9 percent for 2015/2016.

"Our own forecast for inflation for the current fiscal year, excluding the impact of the consumption tax hike is only 1.1 percent. The upshot is that in our view additional monetary easing is still likely to be required," he added.

The second factor that will drive the Nikkei higher is the restart nuclear energy plants that were closed following the Tohoku 2011 earthquake, Capital Economics said, while the government's planned corporate tax hikes and other structural reforms due to be announced in June should also help.

Other economists, including Jeremy Bennett, the CEO of Nomura International, told CNBC that weak performance by the Japanese stock market this year hadn't changed his bullish outlook for Japanese equities.

"A little bit of sentiment goes an awful long way in Japan. You've got companies with cash mountains. So we don't need some massive U.S. consumer boom, we just need a little return of sentiment in that market to go an awful long way," he said.

Ed Rogers, CEO & CIO at Rogers Investment Advisors, told CNBC he expected the Nikkei to strongly rebound as early as the end of this year.

"We do think another strong move upward in Japanese equities will be coming, although our internal estimates for when this happens range from end of Q3 2014 to end of Q1 2015," he said.

"At some point there will be so much overwhelming good news – improved earnings, increased exports, improved wages, lack of problems associated with increase in sales tax etc. – that Japanese equities will start to move again...A 20 to 30 percent increase in the value of the Nikkei can certainly happen over this time period," added Rogers.

However, both Capital Economics Rogers Investment Advisors said the Nikkei's journey is unlikely to be smooth.

"There is still the lingering uncertainty about the effect of the consumption tax hikes and more clarity on these issues is unlikely to emerge before the second half of the year," said Thieliant.

Read MoreMarkets show growing unease over Abenomics

"What's more, the consensus is still that the BOJ will announce further stimulus in July, but this seems increasingly unlikely given the optimistic tone of recent central bank communication," he added.

"There could easily be some more short term negative moves to the downside and individual investors who put money into Japan now could easily get discouraged and sell out on the back of another 5 to 10 percent downside move," added Rogers.

Last week, the BOJ published minutes from its recent meeting which showed no change in monetary policy maintaining its pledge to increase its monetary base by 60-70 trillion yen a year. Board members also agreed that consumer spending remains buoyant following the sales tax rate, due to a tight labor market and improving wages.

Contact Asia Economy

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