Japanese equities look set to brave political headwinds

Japan’s radical economic and political changes, from the return of inflation and rising bond yields to government instability, have caught global investors’ attention. We assess the drivers behind our preference for Japanese equities, and the risks ahead.

The sustained return of inflation and gradual monetary policy normalisation by the Bank of Japan (BoJ) since its 2024 exit from negative interest rates, have been tailwinds for Japanese stocks. The rally has strengthened in recent months, driven by solid growth and earnings prospects, corporate reforms, a better-than-feared US trade deal, and the steady return of foreign investors – driving an 11% rise in the Nikkei 225 index since the beginning of July. We see further upside for Japanese stocks ahead.

A solid macroeconomic backdrop

Japanese growth should be positive this year despite a brief setback and some volatility in consumption patterns. We expect the economy to expand around 1% in both 2025 and 2026. The tariff shock should fade after the first half with the lower 15% rate applied from mid-September. We expect the labour market to remain in good shape, while tax cuts and cash transfers should help households faced with higher food costs. Reflation and rising nominal GDP are supporting earnings upgrades and a solid outlook for 2026.

Japanese companies are also benefitting from a reform agenda which has gained significant momentum this year. Reforms include more active minority shareholders and more oversight of poor performing management, as well as signs of better capital allocation, including non-core asset disposals, rising buybacks and dividends. Such measures are helping improve returns on Japanese equities.

Business activity remains resilient despite trade disruptions, reflecting steady service sector momentum

At the same time, surveys of business activity have been comparatively resilient despite trade disruptions, reflecting steady momentum in the service sector while banks are benefiting from a rising interest rate scenario. Exporters, particularly carmakers, aggressively cut their prices in the second quarter to retain market share, but with the tariff rate set to fall in mid-September, this will probably reverse.

We remain overweight in Japanese equities

We maintain a neutral portfolio positioning in developed market equities globally, however we are positive on Japanese stocks. After years of foreign investors shunning the Japanese stock market, we expect to see their gradual return. Japanese stocks offer portfolios exposure to cyclical sectors like autos and tech hardware sectors, which should perform well in our base scenario of slowing global growth without a US recession. Within our Japanese equity allocations, we favour financials and beneficiaries of corporate reforms.

Of course, we closely monitor the risks. These include political uncertainties, and the danger that investors are too complacent about rising yields, or that the BoJ may yet prove too cautious on tackling inflation. Any subsequently aggressive monetary tightening could damage growth and earnings.

Political challenges and a new PM

On the first – political – risk, Prime Minister Shigeru Ishiba’s resignation on 7 September has sparked a leadership contest within his Liberal Democratic Party. Our base case is that the winner, due to be announced on 4 October, will become the new premier. This political instability has compounded an upward shift in Japanese government bond (JGB) yields this year, refocusing markets on Japan’s fiscal challenges and high levels of public debt, with many long-dated bonds at, or close to, record highs.

The current frontrunners to become prime minister are conservative hardliner Sanae Takaichi, and Shinjiro Koizumi, who holds more moderate views than his father, former Japanese PM Junichiro Koizumi. Mr Koizumi junior would represent more policy continuity, yet Mrs Takaichi favours expansionary fiscal and monetary policies which could further pressure yields.

We think risks over Japan’s debt have been overstated

A period of weak prime ministers now seems likely, and managing multi-party dynamics may in any case drive a modest setback in Japan’s fiscal balance. While radical stimulus is unlikely, the ruling Liberal Democratic Party and its coalition partner are likely to use cash handouts and a temporary cut on value-added food taxes to cement a new coalition framework.

However, we think risks over Japan’s debt have been overstated. The country’s fiscal deficit has been narrowing substantially in recent quarters, while its net savings and current account surplus means it is well able to fund its debt domestically.

Sustained inflation pressures BoJ

We do, however, see some further temporary upside risks to Japanese government bond (JGB) yields, given persistent inflationary pressures. Headline inflation of 3.1% in July was slightly above expectations and remains well above the BoJ’s 2% target. We expect above-target inflation to persist for the remainder of the year and into 2026. Despite positive wage growth, there is growing discontent with the rising cost of living.

Should the market price-in two full additional BoJ hikes, we would see this as an opportunity to re-invest in JGBs

In our view, the BoJ is likely to hold out on its next interest rate hike until January 2026, with a gradual slowing in its bond purchases, especially in light of recent bond market turmoil.

Should the market price-in two full additional BoJ hikes, we would see this as an opportunity to re-invest in JGBs at more compelling valuations. Meanwhile, rising yields and declining hedging costs may yet spark a wave of capital repatriation, including from US Treasuries, a risk we are monitoring closely, but see little sign of yet. Rapid changes in the behaviour of Japanese investors, who hold an estimated USD 3 trillion in foreign assets, could then have profound implications across other markets.

Finally, we expect a weakening dollar and Fed easing at a time when the BoJ is tightening policy to be the primary driver behind some medium-term strengthening for the yen. Our 12-month USDJPY target remains 140.