After nearly two decades of economic stagnation, Prime Minister Shinzo Abe’s massive stimulus program seems to be finally driving Japan’s economy into a period of growth.

Japan’s gross domestic product (GDP) only grew 1 percent in the fourth quarter, another dismal showing in a decades-long period of stagnation. However, earlier this week the government reported that the country’s economy grew by an annualized 3.5 percent in the first three months of this year.

Not only did that pace beat the consensus expectation of less than 3 percent, it also made Japan one of the fastest growing developed economies in the world. For example, US GDP grew by just 2.5 percent and the euro zone experienced a -0.9 percent contraction.

Much of Japan’s growth can be attributed to a substantially weaker yen compared to just a year ago. The value of the yen measured in US dollar terms has fallen more than 21 percent just since November, recently hitting JPY100:USD1. That’s the largest decline of any of the major global currencies, followed by the 14 percent tumble the euro has taken of late.

That’s provided a huge boost for Japanese exporters, particularly automobile manufacturers such as Toyota Motor Corp (NYSE: TM) which have substantial business in the American market. Consumer spending has also picked up, thanks to improved confidence.

As deflation ruled the day in Japan, consumers delayed major purchases in the hopes that the price of goods and services would continue to fall. But the Nikkei is up more than 45 percent year-to-date and 74 percent over the past year. This “wealth effect” is being magnified by the government’s announced intention of pushing inflation up to an annualized 2 percent.

The result: consumers are flocking to the malls. Japanese consumer confidence is currently at a six-year high, while department store sales hit a one-year high in March.

International sales are the major growth driver for Japanese retailers such as Long-Term Portfolio Holding Fast Retailing (Tokyo: 9983), one of Japan’s largest fashion purveyors. However, improved domestic sales will provide a substantial boost to profit growth in the coming quarters.

This rally isn’t riskless, though.

For one thing, while Japanese consumers are clearly undeterred by rising inflation so far, Japan is still an island nation dependent on imports. Japan imports nearly 80 percent of the energy it consumes in terms of crude oil and natural gas.

Japan also imports the majority of its food stuffs, producing just 39 percent of calories consumed according to government data. It also relies heavily on imports to meet demand for staple food stuffs such as soybeans and cooking oil, importing more than 90 percent of those two commodities.

While a 2 percent inflation rate can generally be considered tame, it can be challenging when you consider the fact that Japanese wages have stagnated for years. Any inflation when incomes are flat runs the risk of stifling spending.

There are also dangers lurking in the bond market and the government’s own response to its success.
While the yield on Japan’s 10-year government bond hit an all-time low of 0.315 percent in the wake of the government’s announcement of its stimulus program, it has since risen to 0.868 percent. That’s the highest level since late 2012 and it has prompted Japanese banks to raise the interest rates on both business and consumer loans, on everything from cars and real estate to capital equipment.

Japan is already a deeply indebted nation, so it’s no wonder that bond buyers are getting jittery about the central bank’s plan to purchase JPY7 trillion in government bonds each month. It also doesn’t help that the government also recently passed its largest ever budget at JPY92.6 trillion, to provide additional support to the country’s economy.

The hope is that an improved growth outlook and a new tax that the Diet passed last year will calm bond buyers. Under the new program, the country’s consumption tax will rise from its current 5 percent to 8 percent in April, then to 10 percent in October 2015.

With a government debt-to-GDP ratio in excess of 200 percent, the tax increase is aimed at reducing the country’s debt burden even as it stimulates its way out of recession. While those seem like mutually exclusive goals, debt that high can create a significant drag on economic growth.

While a final decision on whether to implement the new tax program won’t be made until August at the earliest, given the stronger growth environment it appears increasingly likely that it will be approved. Its effect on the economy will be closely watched.

That higher tax rate might not be as great a drag on economic as some fear, if Prime Minister Abe follows through with his proposed program of deregulation.

Thanks to tight regulation, Japan suffers from a moribund labor market that is increasingly reliant on temporary workers. Given the difficulty of firing ineffective or simply unneeded full-time employees, nearly a third of the country’s workforce is made up of temporary workers with little measure of employment stability.

Abe has said that he supports deregulating the labor market and, in the past, has supported changes to Japan’s tax system and elimination of government subsidies to favored industries as well. He’s even supported the creation of online pharmacies which sell over-the-counter drugs via the Internet.

An ambitious deregulation program could be just the ticket for revitalizing Japan’s businesses, which have held off making capital investments as they take a wait-and-see approach to the economy’s true state of health. For now, though, most of the pieces seem to be in place for a Japanese renaissance even as China’s economy slows.

Portfolio Updates

AutoNavi Holdings (NSDQ: AMAP) reported first quarter revenues of $34.3 million, down from $35.7 million in the same period last year and $43.6 million in the fourth quarter.

While earnings were in line with seasonal trends, the company said that sales of its automotive navigation data were down to $15.5 million from $21.7 million in the first quarter of last year. That decline, accompanied by higher expenses largely due to annual salary and benefit increases, helped to slow revenue growth in the first quarter.

There were bright spots in the report, as revenues from mobile and Internet location-based services jump to $13.9 million from $9.9 million last year. Public sector and enterprise applications also showed marked growth, up to $4.3 million compared to $3.6 million in the first quarter of last year.

Unfortunately, though, those results weren’t enough to offset declines in the core automotive business. Net income attributable to shareholders fell to $5.7 million from $8.9 million in the first quarter of 2012.

Despite that setback, management still forecasts earnings growth of between 5 percent and 10 percent compared to last year, as it expects Chinese auto sales to rebound. Investors were also cheered by the news that Alibaba Group, a major Chinese e-commerce company, is investing $294 million into AutoNavi in the form of newly issued preferred and ordinary shares. Alibaba’s investment is aimed at growing its product lineup.

Analysts at Deutsche Bank (NYSE: DB) have bumped their rating of the stock to “buy,” a big win for AutoNavi which has struggled to gain more attention from Western investment banks.

Continue buying AutoNavi Holdings under 15.

Dr. Reddy’s Laboratories (NYSE: RDY) reported that in fiscal 2013 (it’s fiscal year runs from March to March) jumped by 20 percent to INR116.3 billion, as generic sales to North America and Russia grew by 19 percent and 28 percent, respectively. Domestic sales also rose by 13 percent, more than offsetting the 7 percent decline in European revenues. Sales to the rest of the world rose by 42 percent.

The company successfully drove sales volume gains with the launch of several new products in emerging markets, bringing 78 new generic products to market and filing 56 new product registrations.

New products will continue to play a key role in sales growth, aided by Dr. Reddy’s hike in research and development spending from 6.1 percent of revenues to 6.6 percent. The company also should benefit from its 65 applications pending with the US Food and Drug Administration, several of which are up for an imminent decision and likely approval.

Continue buying Dr. Reddy’s Laboratories under its new target of 43.