Relax, Sign Points to Eventual Rally in Japan Stocks

It's a question of when, not if, Japan's large institutional investors will reallocate funds from government bonds into riskier assets including domestic equities, said Shogo Fujita, chief Japan bond strategist at Bank of America Merrill Lynch.

This shift would inject fresh momentum into the nation's recently battered stock market.

Japan's government is set to urge the country's $2 trillion worth public pension funds to increase their exposure to equities and overseas assets as part of Prime Minister Shinzo Abe's long-term growth strategy expected to be announced this week, Reuters reported Tuesday.

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"Bottom line they [Government Pension Investment Fund and Yucho] will start to reallocate funds to more risk assets including equities and foreign assets," Fujita told CNBC Asia's "Squawk Box" on Tuesday, referring to the investment arm of Japan's public pension system and the country's postal bank.

Under its current portfolio strategy, the Government Pension Investment Fund (GPIF), which manages the retirement savings of government employees, targets 11 percent allocation for domestic stocks, according to Reuters, with a 6 percent band to increase or decrease equity holdings from the specified target.

The flexibility of the band will likely be increased, Fujita said, adding that Abe could announce this as soon as Wednesday.

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"The GPIF is a quasi-sovereign wealth fund. They [government] can order the pension funds to diversify into risk assets," he said.

However, Fujita noted that the shift out of government bonds into equities is not going to happen overnight.

"This is going to be a multi-year event. For example, in the late 90s, when the U.S. went down reforms in their pension funds, it took a good part of 10-15 years to get their portfolio together. And Japan will go down the same way," he added.

Japan's Nikkei 225 has undergone a deep correction over the past two weeks, losing over 16 percent, but experts say an official announcement on pension fund allocation could prompt investors to re-enter the market.

What About Other 'Risk Assets'?

While Japanese investors have been net sellers of foreign debt in recent weeks, Steven Major, global head of fixed income research at HSBC, is still betting on a "buying spree" in foreign bonds over the next two years.

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Japanese investors sold 1.12 trillion yen ($11 billion) in overseas bonds in the week ended May 25 after selling 800.6 billion in the previous week defying forecasts that the Bank of Japan's asset purchases would lower domestic yields and push investors overseas.

With Japanese government bond yields rising in the past month, market watchers say this could have lured domestic institutions back into sovereign debt. But this could change as bond yields settle.

"We still expect outflows of at least 600 billion over two years once JGB [Japan government bond] and yen frictions settle down," Major wrote in a report on Monday.

"Of the large bond markets, the U.S., U.K. and core euro zone are expected to benefit. Italy and Spain appear well-positioned too. In emerging markets, Mexico, Turkey and Malaysia are likely to be future targets," he said.