(FORTUNE Magazine) – While other world markets are beset by worries over rising interest rates, Japan's Nikkei average is up 16% so far this year. Is this the beginning of something big? David Thomas, manager of the Putnam Asia Pacific Growth fund, thinks so. He now has 55% of his portfolio in Japanese stocks, up from 20% at the beginning of the year. Thomas expects the Nikkei to rise from 19,800 to 25,000 over the next 12 months. Behind such optimism lies a rash of economic data suggesting that Japan is finally on a recovery track. The housing market is on the mend, industrial production is picking up, machinery orders are rising for the first time in two years, and consumer confidence is improving. Even the political turmoil caused by Prime Minister Hosokawa's recent resignation won't stop the momentum, analysts say.

A firming economy should usher in a long-awaited rebound in corporate profits. Though Japan Inc. will again post a decline in earnings for the fiscal year that ended this March, John Reynolds, global strategist for NatWest Markets in London, expects profits to stabilize by fiscal 1994 and then to jump 40% in fiscal 1995. But investors shouldn't wait for those gains. Warns Reynolds: "If the stock market thinks earnings will be strong in 1995, it will anticipate them 12 to 18 months beforehand." What could jeopardize that recovery? In the short term, the economy still must grapple with the mighty yen. At 105 yen to the dollar, the currency remains too strong to make Japan's massive export sector competitive worldwide. But Sushil Wadhwani, global strategist at Goldman Sachs International in London, forecasts it will weaken to 110 as interest rates rise in the U.S. and sink in Japan and as fears of a trade war recede. A longer-term problem is Japan Inc.'s need to restructure. No longer in a rapid expansion phase that marked their postwar ascent, Japanese manufacturers now employ too many workers and are operating more factories than they need. Says Alexander Kinmont, Morgan Stanley's strategist in Tokyo: "Can Japan operate the same way it did from 1945 to 1985? The answer is no." Some companies are beginning to swallow the necessary medicine, and Wall Street is taking notice. Sony, for example, is slashing expenses, cutting back on new hiring, and shifting production from plants in high-cost Japan to lower-cost facilities in neighboring Asian countries and Mexico. Such cost savings, along with reinvigorated world demand for its consumer electronic gear, should push Sony's operating income up 24% next year, according to Morgan Stanley, which rates it a buy. Investors seeking a broader exposure to Japan may be best served by Scudder's Japan Fund with a reasonable entry minimum, a strong relative performance record, and no sales load.

CHART: NOT AVAILABLE CREDIT: FORTUNE CHART/SOURCE: TRADELINE CAPTION: THE NIKKEI 225 STOCK AVERAGE