No country seems to divide, or confuse, fund buyers as much as Japan. By way of illustration, despite a 10.2% return from the MSCI Japan index in 2024, net retail sales into the IA Japan sector were broadly flat, with the region recording outflows of £40m for the calendar year.
Last year’s performance followed a strong 2023 for the country – with the MSCI Japan up 13.5% – and over three years the index has recorded a cumulative gain of 27.4%. So is it time for investors to put past concerns behind them and start upping their weighting to the region?
Rebekah McMillan (pictured left) of Neuberger Berman and Asset Value Investor’s Nicola Takada Wood (pictured left) share their views on the country for the year ahead.
Rebekah McMillan, associate portfolio manager in the multi-asset team, Neuberger Berman
A combination of macro, geopolitical and regulatory tailwinds could bode well for Japanese equities for the remainder of 2025 and sustain a broader-based rally than in recent years, especially among companies that generate the bulk of their revenues from the domestic economy.
The Bank of Japan (BoJ) kicked off 2025 with a much-anticipated interest rate hike, pushing its unsecured overnight call rate to 0.5% – a 17-year high. This was the first increase in six months and the third under governor Kazuo Ueda, who was appointed to the top spot in April 2023.
We believe the Japanese central bank is gradually normalising monetary policy in a manner consistent with our long-held view that the country is finally emerging from its ‘lost decades’ of deflation.
We expect the BoJ to remain on its normalisation path even as the Federal Reserve aims to adjust monetary policy in the face of uncertain inflation projections. While we anticipate near-term volatility as both central banks react to the latest economic data, we expect the interest rate differential to narrow over the longer term, pushing the Japanese yen higher versus the dollar.
Stronger currencies reduce import costs, and we believe a rising yen could be a boon for household consumption in Japan, as well as for smaller to midsize companies that generate most of their revenue from the domestic Japanese economy.
In recent years, Japan has enjoyed strong foreign direct investment (FDI) from its allies, notably in crucial sectors such as semiconductor manufacturing. FDI in Japan’s semiconductor industry rose 9% year over year in 2023, thanks to double-digit increases from regions including the US, UK and Taiwan.
While near-term uncertainty remains, in light of US president Donald Trump’s ‘America first’ stance and his call for broad-based trade tariffs to support it, we believe Japan’s strategic partnership with the west and other allies will likely hold firm over the medium- to-long term.
Since the end of World War II, Japan has enjoyed a fruitful economic and military alliance with the US and Europe. In light of China’s ongoing rise, we believe this foundational co-operation between Japan and the west – regardless of a temporary trade spat – will likely help support the Japanese equity market over the long term.
Turning up the heat
As for other tailwinds, Japanese regulators have been turning up the heat on the country’s companies since the turn of this decade to improve corporate governance and capital returns, culminating in a 2023 flagship report from the Tokyo Stock Exchange (TSE). In it, the TSE stressed the connection between poor capital management and low stock valuations and urged Japanese executives to achieve higher return on equity to unlock Japan Inc’s true economic potential.
We also expect Japanese companies to accelerate the sale of strategic investments and cross-shareholdings – unlocking capital for new growth initiatives – driven by pressure from shareholders and ongoing regulatory reforms. For example, in October 2026, the TSE plans to implement proposed changes to the inclusion criteria for the benchmark Topix Index. A new liquidity guideline will require new entrants to be among the top 96% of the Topix by free-float-adjusted market capitalisation, and existing constituents must be within the top 97%.
These changes could further polarise winners and losers across the broader Japanese equity market, creating an increasingly attractive environment for active stock selection over the medium-to-long term.
While near-term risks remain, including volatile currency swings from monetary policy adjustments – which roiled equity markets back in August 2024 – we believe near-term pullbacks can provide opportunities to invest in high-quality Japanese companies primed for long-term growth at attractive valuations.
Nicola Takada Wood, managing director Japan, AVI
Japan has had its share of negative epithets during the 30 years we have been investing in its rich market. ‘The lost decades’, ‘Japanification’ and the infamous ‘widow maker’ being some cult favourites.
How things have changed. With the equity market posting strong gains over the past two years, an end to deflation in sight and corporate governance reform in full flow, is now the time to ‘buy Japan’? Absolutely, but not all of Japan.
There’s no denying that Japan is in the midst of a market and macroeconomic revolution, but in this case, a rising tide is unlikely to raise all 4,000 listed company ships.
For the past two years, Japan’s stockmarket has booked stellar performance, with the Nikkei (46%) and Topix (44%) both hitting record highs in July last year. The determinedly weak yen boosted profits at exporters, and some large companies made encouraging strides in corporate governance reform and shareholder return.
In tandem with the now-discontinued buying of ETFs by the BoJ, the result was a vast outperformance of large caps versus small, with the largest 100 companies in the index outperforming smaller companies by almost 20%.
The questions now are what will the next phase of Japan’s recovery look like and who will benefit. The BoJ confirmed its slowly-but surely approach to policy normalisation in January 2025 with a third interest rate hike (+5bps to 50bps), which would potentially lead to upward pressure on the yen and a reversal in fortune for the exporters.
Another headwind for exporters is the yet-unknown ramifications of Trump’s tariffs.
The BoJ’s stance is supported by two years of steady inflation and finally, wage inflation. Last March, corporate Japan raised average wages by 5.3%, the largest hike in 33 years and expectations are high that we will see a similar hike this year, which will be crucial for smaller, domestically-focused companies.
Corporate shake-up
Regulators have rightly been credited with throwing down the corporate governance gauntlet and accelerating the pace of reform. The Tokyo Stock Exchange has put in place extraordinary measures to pressure companies into improving their own valuations and share price performances.
Following a shake-up of exchange categories and listing requirements in 2022, they now compel companies to account for low valuations, particularly those below 1x price-to-book ratios. This places 47% of the stockmarket not only in the TSE’s crosshairs, but potentially in the sights of activists and private equity firms as well.
The opportunity to buy undervalued, unknown, cash-rich companies simply doesn’t exist to this extent in any other developed market. Takeover activity last year reached the highest level since 2007, with both global and domestic private equity firms drawn in by cheap, cash and asset rich companies who now feel overwhelming pressure to improve.
A further boon for smaller companies could be the rise of the retail investor.
Regulators have revamped the Japanese ISA system, with further tax incentives introduced to motivate a move from individual savings into investment.
The number of low price-to-book companies, overcapitalised balance sheets and the degree to which they are net cash, are all notably higher in the small to mid-cap space. In other words, they have far more incremental change ahead than their larger-cap compatriots.
As mentioned earlier though, not all companies will be open to change, and not all companies will be successful at it. They key is to identify and work with those companies that could, with some help, make meaningful improvements to their corporate value. We believe that rather than broad investment in ‘Japan Inc’ the once-in-a-generation ‘rising sun’ of change presents significant opportunities for carefully selected small to mid-cap companies, where corporate governance reforms will have the greatest impact.
This article was written for our sister title Portfolio Adviser’s March magazine
