(Bloomberg) -- Middle East tensions and currency volatility have caused Japan’s record stock rally to falter, but the weakness looks temporary as solid corporate fundamentals and the long-term artificial intelligence outlook provide support.

That’s the view of Koji Nakatsuka, chief investment officer for Japan equity at Allianz Global Investors, which manages $2.4 trillion in assets globally. “If everything gets normalized, the Japanese stock market has an upside potential towards the end of the year. The Nikkei may return to its record high levels by year-end,” he said. 

Japanese stocks have come close to a technical correction after surging to all-times highs earlier this year, as traders slashed bets on the Federal Reserve’s interest rate cuts. That spurred renewed strength in the dollar and pressured the yen, which has weakened to near 155 against the greenback. It’s a level that has raised concerns on possible intervention by authorities and triggered warnings from Wall Street brokerages, at a time when rising geopolitical stress is prompting a flight to safety.

It’s highly likely that the yen will weaken to 155-158 per dollar, said Nakatsuka, but “most market participants are already expecting the government to intervene, so it’s difficult to continue buying the dollar and shorting the Japanese yen.” Domestic-oriented small-cap stocks that benefit from a stronger yen will start to catch up with their bigger peers that have been leading the rally over the past year.

The small-caps have more niche players with distinctive AI expertise, he said, adding that the corporate reform campaign will eventually broaden out to the nation’s smaller firms as well. An index of small-cap firms has returned just 6% over the past year, lagging the 35% return in a large-cap gauge.

As oil prices remain elevated after touching this year’s high earlier in April given heightened tensions between Israel and Iran, growth stocks are “very vulnerable,” especially fine chemical companies that import basic material in dollar terms, according to Nakatsuka. “The input cost is so high that their profitability may be squeezed.”

Meanwhile, China’s uncertain economic recovery path has triggered Allianz to trim Japanese stocks with exposure to Asia’s biggest economy starting from last year, including steel, factory automation and machinery companies. “I think that was the right decision,” he said. “It’s a structural problem and it may take a few years to recover.”

Even after the Bank of Japan exited its negative interest rate policy last month, the asset manager is staying overweight in banks and developers in spite of their underperformance in past rate hike cycles. “Previously when the BOJ increased the interest rate, that was the best timing to sell banking stocks. But this time I decided to keep holding financials because the BOJ is likely to increase the interest rate again in the second half of this year,” he said.

The next catalyst for Japanese stocks will be first—quarter earnings due over the next few weeks, with tech shares likely to show a better performance, he said. “Even without the depreciation of the Japanese yen, corporate earnings should be marginally positive for AI-related names and electronic component companies. And momentum for automakers is improving in the long term.”

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