Market watchers are expecting Tokyo stocks to enjoy a bull run in 2007, thanks to improved corporate performances and a solid economic recovery.

The dollar meanwhile is expected to soften somewhat against the yen as the gap in interest rates between Japan and the United States narrows on expected monetary tightening by the Bank of Japan and a possible rate cut in the U.S.

Along with U.S. and Japanese monetary policy, the focus of attention for financial markets in 2007 will be whether Prime Minister Shinzo Abe’s Cabinet continues the reforms started by Junichiro Koizumi.

Stock traders and analysts predict the 225-issue Nikkei average on the Tokyo Stock Exchange is likely to range between 15,500 and 19,000 in 2007.

Some said the Nikkei could reach as high as 22,000 if the Abe Cabinet is able to push through further reforms after the House of Councilors election slated for July, and if the market handles any U.S. rate cuts smoothly.

The dollar is expected to trade between 105 yen and 120 yen in 2007, according to currency analysts.

“We expect 10 percent earnings growth each in the business years ending March 2007 and March 2008 (based) on improved fundamentals, and that should give a boost to stocks,” said Tsuyoshi Segawa, equity strategist at Shinko Securities Co.

Masatoshi Sato, senior strategist at Mizuho Investors Securities Co., said a legal change expected in May that will allow so-called triangular mergers should also help the market. “Stocks may rise on expectations over global realignment in industry,” he said.

Triangular mergers will allow Japanese subsidiaries of foreign corporations to acquire Japanese firms by swapping shares of the parent firm for those of the target, without the need for cash to finance the acquisition.

“It will prompt Japanese companies to carry out structural reforms in an attempt to heighten their corporate value to counter takeovers, which will work to lift their shares,” said Kazuhiro Takahashi, head of equity planning and administration at Daiwa Securities SMBC Co.

Foreign investors, who account for roughly 60 percent of Japanese stock markets’ trading value, are expected to step up purchases of stocks. Japanese equities are widely seen as undervalued, given the probable upward revisions in earnings, said Hiroaki Kuramochi, head of equity sales at Bear Stearns (Japan) Ltd.

Stocks are also expected to get a boost from an improved supply-demand balance as more baby boomers shift their retirement funds into the market, brokers said.

An increase in domestic stock investors is expected to offset the tumble in markets for startup companies following the arrest early this year of Takafumi Horie, former head of Internet services firm Livedoor Co., and Yoshiaki Murakami, a once-celebrated investment fund manager.

Horie was arrested in January over alleged accounting fraud and market manipulation aimed at raising the Livedoor group’s share price, and Murakami was taken into custody in June for alleged insider trading.

“The market is recovering its health as individual investors are taking more autonomous actions and not jumping at popular stocks. The maturity of such investors will certainly be a tail wind for the market in the future,” said Shinko Securities’ Segawa.

But the market may run into trouble if the ruling Liberal Democratic Party suffers a major setback in the Upper House election, some market analysts said.

“A defeat would be a major blow to the Abe administration . . . as it would raise serious doubts about the fate of Japan’s fiscal reform and its economic recovery,” said Hiroyuki Nakai, chief strategist at the Tokai Tokyo Research Center.

A number of recent media polls show that support for Abe’s Cabinet is falling, due partly to his decision to readmit 11 “postal rebels” who were ousted by Koizumi for opposing his postal privatization bills.

Other factors to watch are possible financial scandals as well as the U.S. economy.

“Stocks could nosedive if another ‘Livedoor shock’ comes at a time when the Bank of Japan is carrying out rate hikes, as it may prompt foreign investors, who are cautious over the credibility of Japanese corporate accounting, to flee from the Japanese market,” Bear Stearns’ Kuramochi said.

The U.S. Federal Reserve kept its key short-term interest rate target unchanged at its Dec. 12 meeting, holding rates steady at 5.25 percent for the fourth straight time, amid an economic slowdown despite persistent inflationary pressures.

But many brokers see the U.S. economy as recovering from its slowdown toward the end of 2007, expecting the Bush administration to pump up the economy ahead of the 2008 presidential election.

If the United States sees slower growth and the Fed cuts interest rates later in 2007, it will send the dollar down against the, yen which will eventually reduce the profitability of Japanese exporters that have kept the market here afloat, said Daiwa Securities SMBC’s Takahashi.

Currency dealers also foresee possible rate cuts in the U.S. in late 2007. They said the dollar is likely to enjoy solid demand against the yen for now because foreign assets still offer a higher yield than those in Japan, given that interest rates here are so much lower. The BOJ held a key short-term rate steady at 0.25 percent at its Dec. 19 meeting, after ending its “zero-interest rate” policy in July.

“The market’s focus should change later in 2007 as we expect the Fed to start cutting rates and the European Central Bank to halt rate hikes,” said Susumu Kato, chief economist at the Tokyo branch of Calyon Capital Markets Asia.

The euro topped 156 yen on Dec. 20 for the first time since its introduction in 1999 on the back of growing confidence in the European economy. It also rose against the dollar on persistent concerns about the huge U.S. trade deficit.

The euro remained strong throughout 2006 as the ECB has aggressively hiked rates over the past several months, while U.S. and Japanese interest rates remained unchanged.

But with the steady recovery of the Japanese economy and a record-high U.S. current account deficit logged in the July-September quarter, the yen will gain momentum against the dollar and the euro, rising to as high as 105 to the dollar and 140 to the euro toward the end of 2007, Kato predicted.

“The downside of those currencies against the yen may be limited as yen-carry trade — in which investors borrow cheap funds in Japan to invest in higher-yielding assets elsewhere — will expand, (and) the absolute rate differentials between the yen and other major currencies remain,” said Etsuko Yamashita, chief economist at Sumitomo Mitsui Banking Corp.

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