Japanese stocks were up about 20% this year. Investors say the rally is not over

• Since the end of last year, the Nikkei 225 has increased around 16.4% while the Topix has risen roughly 19%.
• But Morgan Stanley, UBS and Nomura have predicted that Japanese equities could climb even higher in 2020, driven by a recovery in corporate earnings.
• The three banks outlined the sectors in Japan that they like, which include machinery, financials and wholesale trade.

A pedestrian holding an umbrella walks past the Tokyo Stock Exchange, operated by Japan Exchange Group, in Tokyo, Japan, on Wednesday, Aug. 30, 2017.

Kiyoshi Ota | Bloomberg | Getty Images

Japanese equities have climbed about 20% so far this year — but several major investors said they're expecting further gains in those stocks in 2020.

An expected recovery in Japanese corporate earnings will drive their stock prices higher, predicted Morgan Stanley, UBS and Nomura. That comes after two consecutive years of earnings declines in Japan, due largely to a stronger yen and U.S.-China trade tensions, said UBS.

Such anticipation has resulted in a recent rally in Japanese stocks. The Nikkei 225 index rose 16.1% from a low of 20,261.04 in August to peak at 23,520.01 earlier this month. The Topix index saw similar gains, climbing 15.7% from 1,478.03 to 1,709.67 around the same period.

Since the end of last year, the Nikkei 225 has increased around 16.4% while the Topix has risen roughly 19%. Nomura predicted the two indexes will climb to 25,000 and 1,850, respectively, by the end of 2020.

"Japanese stocks have been shown to have a strong cyclical flavor, and appear likely to come into their own as expectations rise for a global economic recovery," Nomura analysts wrote in a report earlier this month.

What stocks to buy?

To be sure, economic growth in Japan is still expected to remain sluggish — one reason why many investors have stayed away from Japanese stocks before the recent rally.

Economists from Morgan Stanley have even forecast zero growth in Japan in 2020. But the bank's equity analysts said "positive structural trends" in the country — such as improving corporate governance and profitability — could help Japanese stocks to maintain or increase their value.

In addition, the U.S. dollar is expected to edge higher versus the Japanese yen by March 2020, said Nomura. That would benefit Japanese companies that generate income overseas, such as exporters, according to the bank.

These are the banks' recommendations for Japanese stocks:

• Morgan Stanley: Overweight IT and services, financials excluding banks, wholesale trade and construction; underweight food, retail, pharmaceutical and autos
• UBS: Focus on "quality companies with steady dividend payout," firms embarking on organizational transformation, and those with sustainable and ethical business practices
• Nomura: Top picks are machinery, and electric appliance and precision instrument sectors; IT and services stocks could underperform