Why Japan Equities Sold Off on Abe's Plans

Getty Images

It's time for Japan to become an engine of global economic recovery, said Prime Minister Shinzo Abe as he kicked off his highly anticipated speech addressing how the government plans to drive longer term growth in the world's third largest economy on Wednesday.

But plans outlined by Abe , ranging from setting up special economic zones to attract investment and raising incomes by 3 percent annually over the next 10 years, weren't enough to excite equity investors.

After briefly rising 1.25 percent minutes after the speech began, the Nikkei 225 promptly slipped into negative territory, closing down almost 4 percent on Wednesday.

Abe's economic strategy, dubbed "Abenomics" rests on "three arrows:" monetary and fiscal stimulus to get growth going and long-term structural change to ensure sustainable growth.

(Poll: Does Abe's 'Third Arrow' Go Far Enough? )

But investors were disappointed on Wednesday from the lack of announcements on reforms surrounding the labor market and corporate taxes and failure to urge public pension funds to increase their equity allocations, said market participants.

"There was nothing really game changing - we have heard pro-growth comments for some time," said Stan Shamu, market strategist at trading firm IG Markets.

"The market was looking for comments on public pension funds increasing equity investments," he added.

(Read More: Relax, Sign Points to Eventual Rally in Japan)

In his speech on Wednesday, Abe was expected to press the country's giant public pensions funds to reallocate funds to more risk assets including equities - a move that would inject fresh momentum into the market that has undergone a sizable correction over the past two weeks.

John Woods, chief investment strategist, Citi Private Bank, said he was looking for details on reforming the country's strict labor laws, which make it difficult to shed surplus workers.

Addressing the sell-off in the equity market, Woods said that it reflects a very dramatic pricing in of expectations over the past two quarters. "Possibly the market had overbought and got ahead of itself," Woods said.

According to Takuji Okubo, principal & chief economist, Japan Macro Advisors, the Nikkei 225 may have already reached its peak, referring to the near 16,000 level hit last month.

"'Abenomics' has had a very good run for the first half of the year and now unless we start to see new ideas I think financial market wise, 'Abenomics' could be over now," Okubo said.

"We won't see a collapse in Nikkei yet. But it will be hard to get back to levels it reached two weeks ago," he said.

Shamu of IG Markets, however, disagrees that it's downhill for the Japan market from here, noting that heading into the country's Upper House elections in July, Abe and Bank of Japan Governor Haruhiko Kuroda are likely to ramp up rhetoric which will be positive for equities.

"They will really want to see the Nikkei trade higher and lift confidence in the country."

By CNBC's Ansuya Harjani