Have investors been too harsh on Japan?

People walk through a shopping street in Sendai, Miyagi Prefecture, Japan.
Tomohiro Ohsumi | Bloomberg | Getty Images

The stock market darling of 2013 has lost some of its luster this year, but according to Capital Economics, investors are being too harsh on Japan.

After standout gains of 55 percent last year, sentiment appeared to shift at the start of 2014 with the Nikkei 225 becoming the worst performing Asia Pacific market in the first quarter. The index did recover some of its losses this week on yen weakness, hitting a one-month high on Thursday, but is still down more than 7 percent year to date.

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Worries over the impact of Japan's consumption tax hike – which was implemented on April 1 –have shaken market sentiment as investors fret over how higher taxes will dent discretionary spending at a time when the economy's starting to gain traction.

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While Marcel Thieliant, Japan economist at Capital Economics, recognizes that the tax hike will hurt the economy, he says continued weakness in the domestic currency would help alleviate the pain.

"The economy will surely contract this quarter as households restrain spending in response to the consumption tax hike. Sluggish wage growth doesn't bode well for consumer spending either," he said.

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"However, Japan's large corporations derive an ever larger share of their earnings from activities abroad and, if the yen continues to weaken as we expect, their profits should continue to improve," added Thieliant, noting that anticipated corporate tax cuts and other structural reforms, will eventually bolster profits too.

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Prime Minister Shinzo Abe's ambitious radical economic reform plan, involving aggressive monetary easing, fiscal stimulus and structural reform, has helped boost growth and inflation levels in the world's third largest economy; while a steep decline in its currency of around 22 percent against the greenback in 2013, has given a strong boost to exporters.

At the end of last year, gross domestic product growth came in at a disappointing 0.7 percent in the final quarter, down from an initial estimate of 1 percent.

However, Capital Economics' Thieliant said there were some encouraging signs that showed Japan's economy picking up speed, despite weaker growth at the end of last year.

"Output and activity indicators indicate that the economy picked up speed in the first quarter following a lackluster performance at the end of last year," he said.

"The outlook for business investment remains positive, but housing investment is set to fall sharply in response to the sales tax hike," he added.

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Japan's economy is burdened with one of the largest government debt piles in the world at almost 250 percent the size of the economy, and the sales tax hike is seen as an essential part of reducing the pile.

Other analysts told CNBC the sales tax hike would inevitably have a bearish impact on the economy, but they doubted the move would derail the economic recovery substantially.

"I think there will be a sharp drop in consumption and of course growth in the second quarter, but we don't think it to be as bad as it was in 1997. The growth in 1997 was much worse there was an Asian financial crisis brewing around the corner and they were also dealing with a domestic financial crisis," Izumi Devalier, Japan economist at HSBC, told CNBC.

The sales tax increase enacted in 1997 is widely believed to have tipped the economy into severe recession.

Ed Rogers, CEO at Rogers Investment Advisors, told CNBC the sales tax hike would not be enough to derail the positive psychological impact that Abenomics was having on the Japanese consumer.

"If the stock market is a leading indicator, you wouldn't know that all of a sudden the sky has fallen because of the sales tax," he said, referring to gains seen this week.

"The psychology around Abenomics, which is making people in Japan more comfortable that finally inflation is coming back, that's going to be what helps them to spend money as much as anyone else," he added.

Rogers added that weakness in the Japanese stock market in the first quarter of this year was largely due to fair weather investors leaving the market and said he expected the Nikkei to see a strong rebound in the third quarter of this year.

"The Asian investment tourist stopped coming to town over a couple of months but serious long term investors, not at all. For a longer term investor there is still tremendous value in Japan," he added.