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Written by: Stephen Way | AGF
In 2024, the Bank of Japan (BoJ) raised interest rates for the first time in over a decade, signaling a significant shift in monetary policy. Japanese equities responded positively, reaching new highs as investors anticipated that the driver of the BoJ rate hike – the strongest Japanese wage gains in years – would boost consumer spending and economic activity. Government support for wage increases has been central to the government’s economic strategy, and the interplay between tighter monetary policy, wage growth and political backing has created a pivotal moment for Japan’s economy, raising hopes for long-term stability and growth.
The economic rebound is being driven by a shift from deflation to reflation, marking a dramatic transformation after years of sluggish growth. For much of the past two decades, deflation stifled wage growth, consumer spending and overall economic activity. However, we believe the current environment is markedly different, as rising wages, increased inflation expectations and improved corporate pricing power support a more robust economic backdrop. Companies are now able to pass on rising costs to consumers, which is enhancing profitability. Goldman Sachs forecasts strong earnings growth for the Tokyo Stock Price Index (TOPIX), projecting earnings per share growth of 8%, 9% and 7% for fiscal years 2024, 2025 and 2026, respectively, assuming a yen/USD exchange rate of 150.
The Bank of Japan is expected to continue its path of gradual interest rate hikes towards its goal of normalizing the ultra-loose monetary policy that has been in place for years. Real interest rates should remain negative, however, maintaining a stimulative environment. This supportive monetary stance is likely to continue encouraging economic growth and corporate profitability.
Companies are now able to pass on rising costs to consumers, which is enhancing profitability.
One potential risk to this positive outlook is the possibility that U.S. president-elect Donald Trump makes good on his campaign promise to impose a 10% tariff on all imported goods. Such a tariff could negatively impact Japan’s economy, adding a layer of uncertainty to the outlook. Despite this risk, Japan’s economic fundamentals appear strong, and the correlation between the yen and Japanese equities has weakened. Corporate earnings and structural reforms now play a more pivotal role in driving stock performance. We will closely monitor this transition from deflation to reflation as it unfolds.
Japan’s market is underpinned by the 4Rs: reform, restructuring, reflation and reshoring. Government reforms are enhancing corporate governance and labour flexibility, while corporate restructuring is boosting profitability and efficiency. Reflationary trends support earnings growth, and reshoring is driving domestic job creation. These structural positives are improving Japan's global competitiveness and addressing economic challenges. Following losses in the lower house election, the Liberal Democratic Party (LDP) is expected to form a broader coalition with the Democratic Party (DPP), potentially leading to a supplementary budget exceeding last year’s 13.2 trillion yen. This increased spending is anticipated to stimulate economic growth and enhance investor confidence in the short term.
One of the most compelling aspects of the Japanese equity market is its attractive valuation, particularly when compared to global peers like U.S. equities. Despite a strong rally this year, it is our contention that Japanese stocks remain undervalued and that the structural changes noted above are now gradually shifting investor sentiment. This virtuous cycle is creating a more dynamic and growth-oriented environment for investors.
A key driver of opportunity in Japan’s equity market is the relatively low investor positioning. Despite the ongoing rally in Japanese stocks, investor interest remains subdued compared to markets like the U.S. This underexposure suggests Japan could see increasing inflows, particularly as global investors seek to diversify into less crowded, more compelling markets. Additionally, cash and deposits held by Japanese households still account more than half of total financial assets, significantly higher than the U.S., where cash and deposits account for barely 13%. Japan’s elevated cash holdings were largely driven by the deflation, putting a large portion of household wealth on the sidelines. If reflation continues, it presents the potential future capital deployment into equities and other investments.
As investor confidence grows and if more capital flows in, Japan’s equity market could see further upside. A surge in shareholder activism has also led to greater engagement and positive developments within companies. Moreover, share buybacks through the first 10 months of 2024 surpassed the total for all of 2023, reflecting growing corporate confidence and a favorable outlook for shareholder returns. With these dynamics in play, Japanese equities offer compelling potential for meaningful returns in 2025 and beyond.
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