By Martin Hutchinson
Director of Global Investing Research
When Shinzo Abe, Japan's prime minister, suffered an election defeat recently, some investors at first thought it was bad news. You see, it was Abe who had followed the pro-market policies of the previous prime minister, Junichiro Koizumi, and in doing so pulled Japan out of its 13-year recession.
The reality is that this election may turn out to be very good news for investors, at least in the short term. Let me explain.
Anatomy of an Election
The election was not for the main Diet, the body that elects prime ministers (Japan has a British-type parliamentary system, not a presidency). Instead, it was for the upper house, and only half the upper house seats were up for re-election. Abe's party lost its upper house majority, dropping from 133 seats out of 240, down to 105.  However, he still has a solid majority in the Diet itself, elected less than 2 years ago. So while fairly badly dented politically, there's no real need for him to resign.
[A caveat here. Japanese politics are even more inscrutable than most, and the opposition and some newspapers are calling on Abe to resign, even though he doesn't constitutionally need to. He probably won't, but in politics you never really know. Finance is so much easier to fathom...].
The Outlook for Interest Rates          Â
A dented Abe probably won't make much difference to economic policy. Some opposition figures are claiming that the vote represents popular opposition to Abe's market-friendly policies, but there's no real evidence of this, and the economy's doing pretty well. More likely, it's a result of a complicated scandal in Japan's pensions ministry. Trust me, you don't want to know the details. But suffice it to say that complicated government I.T. programs are as flawed in Japan as they are everywhere else, and the contribution data of about 12 million pensioners seems to have been lost.Â
However, there's one area in which Abe's new weakness matters. For the last year, the Bank of Japan has been trying to raise short-term interest rates, which at the time of the election were at a ridiculously low 0.5%. But Abe's government has been opposing them.
A weaker Abe means less-effective opposition. And if the opposition were to come to power, that group would want the rate increase to have already taken place; that way, it could be the blame or fallout.
Thus rates are likely to go up, although probably slowly: Maybe by as much as 1% by the end of the year, and perhaps by as much as 2% in 2008.
In most countries, this would be bad news for investors - rising interest rates very often choke off an economic recovery. But in Japan, the huge pool of personal savings makes that highly unlikely. You see, Japan's savers have been getting lousy returns for over a decade. Interest-rate increases will, in effect, give investors more money.
Their real effect, however, will be on international hedge funds. These operators have been borrowing cheap yen in huge amounts, and then investing in higher-yielding currencies, such as U.S. dollars, Aussie dollars, and New Zealand dollars.
The Plays to Make
Higher-yen interest rates will stop this little game - not because there won't still be a problem - but, rather, because the risk/reward ratio will become too unfavorable. When that happens, the yen is likely to zoom upwards; and once it starts moving, the hedge funds will all panic and try to bail out simultaneously.
If the yen zooms upward, there won't be much bad effect on the Japanese economy - the place runs a thumping trade surplus, so it can easily absorb an upward move of as much as 20% to 25%. However, foreign investors in Japanese shares will benefit, because the value of their yen-denominated assets will rise.
So here's the bottom line. Make sure that Abe is going to hold on. Then consider buying a Japanese market ETF, maybe the iShares MSCI Japan Index (NYSE:EWJ). Better still, buy the Russell/Nomura "Spider" for Japanese small-cap firms (AMEX:JSC). Small companies are usually more domestically focused, will benefit from Japanese savers having more money to spend, and won't lose from now-less-competitively priced exports.