HONG KONG :Global hedge funds offloaded Japanese equities at the sharpest pace in almost two-and-a-half months last week, just ahead of the country's upper house election on Sunday, Goldman Sachs said in a note.

Sunday's election dealt a major blow to Prime Minister Shigeru Ishiba and his ruling coalition, just as investors who had been selling Japanese bonds and stocks in the run up to the election had expected.

Japan's benchmark Nikkei 225 and Topix have dropped 1.7 per cent and 0.6 per cent, respectively so far this month, bucking the rally in other stock markets.

Both indexes closed down on Friday.

Sunday's outcome further weakens Ishiba's grip on power, even though he has vowed to remain party leader to complete trade tariff negotiations with the United States.

The selling by hedge funds between July 11 and July 17 was mainly driven by increased short bets and a relatively moderate reduction in long positions, according to a Goldman Sachs prime brokerage note on Friday, seen by Reuters on Monday.

Markets in Japan were closed for a holiday on Monday, but the yen strengthened while Nikkei futures rose slightly, as the election results appeared to be already priced in.

Overall, hedge funds remain overweight Japan compared to its weight in the MSCI World Index by 0.6 per cent, Goldman said.

Analysts said uncertainty about the prime minister's future has increased and could lead to "policy paralysis" and larger fiscal deficits.

"This marks the first time since 1955 that the LDP-led government has fallen below a majority in both the lower and upper house, potentially increasing political instability in Japan," MUFG analysts said in a note.

Hedge funds dumped Japanese stocks ahead of upper house election, says Goldman