By Hideyuki Sano
TOKYO (Reuters) - Japanese Prime Minister Shinzo Abe has seen his popularity slump ahead of a local election in Tokyo following scandals and gaffes by officials close to him, but the stock market is betting that a poor showing by the premier's party would be good for shares.
Investors believe a setback for Abe's Liberal Democratic Party (LDP) in Sunday's Tokyo Metropolitan Assembly election, seen as a bellwether for national politics, would spur him to act to boost the economy.
Japanese shares <.MIJP00000PUS> have risen more than five percent this quarter, even more than MSCI's world stock index <.MIWD00000PUS> which covers 46 markets.
That outperfomance, the first time in three quarters, came as Abe's popularity, which looked rock-solid just a few months ago, suddenly crumbled.
A survey this week by Jiji news agency showed that the Abe's LDP was expected to lose about a third of its seats in the capital's assembly, possibly ceding a majority to a new party formed by popular Tokyo Governor Yuriko Koike.
Yet few investors, including event-driven hedge funds that typically make large bets on political events, are selling Japanese stocks. Nor are they betting that the safe-haven yen, which traditionally takes off as the environment gets riskier, will rise.
"They think Abe will come up with some economic measure that is friendly to voters if his rating falls. They think Abe knows the rhythm he needs to buoy the government," said Kyoya Okazawa, head of global markets, Japan and Korea, at BNP Paribas.
Abe wants to accelerate plans to amend Japan's pacifist constitution and he expects to submit a proposed revision to lawmakers before the end of the year.
Investors suspect Abe will need economic stimulus to please voters and achieve his long-term ambition.
"Abe's timeline on constitutional reform hints at a positive feedback between the national agenda and pro-growth economic policy: Not only can we safely rule out a premature policy tightening, but now the probability of added policy easing has risen," wrote Jesper Koll, head of WisdomTree Japan, an equity fund.
"The more ambitious the constitutional agenda, the greater the imperative to create a stronger 'feel good' factor for the voting public," he added.
Some investors think markets may be underestimating the impact of the election.
Masafumi Yamamoto, chief currency strategist at Mizuho Securities, said a clear-cut defeat in the upcoming Tokyo election is likely to raise more awareness about the likelihood that Abe's LDP will lose seats in the next national election, which must be held by late 2018.
"The LDP's retreat could be seen as 'the beginning of the end' of Abenomics, which has been the main driving force of the yen's fall and rallies in Japanese stocks," he said.
(Reporting by Hideyuki Sano; Additional reporting by Linda Sieg and Kentaro Sugiyama; Editing by Eric Meijer)