Japan's economy has been the biggest story in global investing over the past year. In that time, Japan's Nikkei 225 (NIKKEIINDICES:^NI225) stock index has roared to gains of more than 47%, fueled by a combination of unprecedented stimulus and a weakening yen that has reignited growth in the Japanese economy after more than two decades of stagnation. The Nikkei's ranked among the top global markets in the world despite a year where major indices rallied worldwide, and it has investors seeing green in 2014's encore.
But is Japan's economy hiding lurking dangers that could put a swift end to this nascent growth story? Let's look at three big threats that could put a stop to Japan and the Nikkei's hype this year.
Can Abenomics keep up?
"Abenomics" is the word for Prime Minister Shinzo Abe's aggressive initiative to jump-start Japan's growth, and so far, so good. Japan's economy is projected to grow by 2.6% for the fiscal year that began last March, and in 2014, the IMF projects Japan's GDP to climb by 1.7%. That's a much better sign of a stable economy than the economic doldrums that have hung around Japan for two decades.
However, Abenomics isn't a miracle cure: It hinges on the combination of higher inflation, growing trade, and other events. Shinzo Abe's goal is for Japanese inflation to hit 2%, but it's nowhere near that number yet. In fact, in its most recent World Economic Outlook, the IMF said that Japan's inflation goals might not be met by 2015 without further stimulus measures.
While inflation might not meet Abe's 2% goal this year, the turnaround from years of deflation so far have been a blessing for investors. Abenomics' stimulus initiatives have fired up a new wave of export-led profit growth in some of the Nikkei's top companies. Global Japanese firms such as Toyota (NYSE:TM) have taken advantage of inflation and stimulus's effect of weakening the yen to reap profits from overseas and buoy their stocks. While Toyota's seen competition in Asia push up against sales, the company's turned soaring revenue from North America and the falling yen into increased profit expectations for the current fiscal year, something that's helped boost Toyota's shares by 24% over the past year.
However, investors and experts will expect to see more out of Japan's rise this year. If inflation fails to capitalize on its 2013 momentum in 2014, or if growth in the country's exports slows, investors and economists will begin to lose confidence in Abenomics' power to reignite the Japanese economy. That may force Tokyo to launch a new round of stimulus -- and that brings up its own major challenge for Japan's economic goals.
Will soaring debt drown Tokyo?
Stimulus has been a great move for Japan's economy so far, and the Bank of Japan's commitment last April to double the country's monetary base by the end of 2014 has kept the yen falling against other major currencies. However, it's also brought the shadow of Japan's public debt right to the forefront of the debate over the country's economic turnaround.
Japan's public debt burden is the largest in the world and surpassed the one quadrillion yen mark last August. More than half of Tokyo's tax revenues go toward servicing the debt, and its increasing weight on the economy has forced Shinzo Abe to consider measures such as tax increases to relieve that burden. However, while these measures so far haven't derailed Abenomics, the worsening debt problem could mean more drastic measures from Tokyo will be necessary in the near future. The Organisation for Economic Co-operation and Development has even chimed in, cautioning that addressing the debt issue is a top priority for Japan's economic future.
Other economic woes aren't helping the debt. Japan posted its largest November trade gap in recorded history last year, and Tokyo desperately needs exports to pick up some of the slack.
You shouldn't expect any sort of sovereign debt crisis in Japan this year like the kind that has threatened Europe. Still, the real possibility that Tokyo could take further measures to slow and reverse its debt growth -- measures that very likely could weigh on the country's economic growth and stymie any further plans for stimulus injections -- needs to remain in any Japan investor's outlook.
Can China and Japan be friends?
Of course, Japan's domestic initiatives aren't the only actions that can hurt the country's economic objectives in today's global community. In particular, Japan's future will depend heavily on the future of its top rival in the Asia-Pacific region: China.
Much has been made lately over deteriorating Sino-Japanese political relations, particularly over the countries' spat regarding ownership of the Senkaku Islands. The chance of a feared military conflict between the countries any time soon is virtually zero, but Japan can't afford to jeopardize its economic relationship with the world's second-largest economy in 2014. China's become far too important a cog for the country's leading companies -- and its economic turnaround -- for Tokyo to allow political tension to affect trade.
The Senkaku dispute already has stretched over into damaged economic ties at least once, as protests in China against Japanese automakers such as Toyota led to falling sales in the country last year -- sales that only recently have returned to strong growth. Other leading firms, such as industrial leader Komatsu (NASDAQOTH:KMTUY), are counting on China's standout economic growth to fuel their own profit gains. Komatsu's suffered from the collapse of the mining industry in the wake of the recession, but the company counts on China for more than 8% of its sales. A poor flash purchasing manager's index reading for China just this week was enough to send Komatsu's stock sliding.
If Japanese firms can't make the most of China's growth in 2014 -- or if Tokyo and Beijing can't get along -- Japan's economy will struggle to find momentum overseas in markets outside the United States.
Momentum in hand, but challenges await
Just because Japan's economy's facing tough challenges doesn't mean you should panic. Momentum's still on Japan's side, and the country's GDP is on pace for respectable growth in 2014 despite these hurdles. The Nikkei's made the most of Abenomics so far, and investors who got in early on Japan's comeback story in 2013 made out with handsome rewards.
However, past performance is no indicator of future results. If Japan can't keep inflation and growth on target, or if it loses a handle on either its debt or its relations with pivotal trade partner China, the country's economic turnaround could be short-lived -- and Japan investors may see their expectations for a repeat performance of the Nikkei's big 2013 gains left unfulfilled.
Fool contributor Dan Carroll and The Motley Fool have no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.