A fresh bout of weakness is set to fuel further gains in Japanese stocks, but the economy's wobbly recovery may limit the upside, say strategists.
The yen weakened to a fresh six-year low of 108.39 against the U.S. dollar late Wednesday after the Federal Reserve's guidance on interest rates sent the dollar higher. This provided fresh impetus for Japanese stocks, sending the up over 1 percent to 16,051 on Thursday.
"The Nikkei has been struggling to get back to January highs of 16,320, but with this new development on the U.S. dollar front, we would expect the Nikkei to test that level in the next few weeks," Stan Shamu, strategist at IG told CNBC. "I expect any dips in the index will be bought into."
The inverse relationship between the Nikkei and the yen is one of the foreign exchange market's long-established trends. In the first half of the year, investors faced a stronger yen, fueled by risk aversion amid geopolitical tensions and economic concerns.
Nicholas Ferres, investment director at Eastspring Investments, who moved to an overweight position in Japan in July, agrees the yen's slide will help further the rally. However, he noted there's more to Tokyo stocks gains than yen weakness, highlighting attractive valuations and improving corporate profits.
"Japan has had inferior return on equity or profitability relative to the world for some time, however it has improved or narrowed the gap over the past year or so," he said.
The Nikkei has been on a roller-coaster ride this year. It fell sharply over the first five months, but recovered most of those losses on positive earnings momentum and speculation that the Bank of Japan may provide additional stimulus to prop up the struggling economy.
The April sales tax hike – to 8 percent from 5 percent – dealt a severe blow to Japan's fragile recovery, with the economy contracting an annualized 7.1 percent in the second quarter, worse than initial estimates of 6.8 percent.
Hiromichi Tamura, chief strategist at Nomura Securities says concerns around the macroeconomic environment will cap gains on the index.
He pointed to the much anticipated July industrial production data which grossly missed estimates. Output rose by 0.2 percent from June, less than the 1 percent gain forecast.
Based on these macro developments, the bank lowered its year-end target for the Nikkei to 17,000 from 18,000 earlier this week.
Nevertheless, Tamura expects the Nikkei to hit 16,500 by month-end, an almost 3 percent upside from current levels, as stocks ride the renewed wave of yen weakness.