Global Market Strategist
Global Market Strategist
In Brief
- Japan has entered a reflationary phase, supported by sustained wage growth, firm domestic demand, and improving pricing power. Business sentiment is recovering, and capital expenditure is holding up, led by AI investment and semiconductor capacity expansion.
- The Japanese yen (JPY) is challenged by an evolving policy mix, with more active fiscal support alongside gradual BoJ normalization. Flows and positioning also add further pressure on the yen.
- The outlook for Japanese equities remains supported by earnings momentum, weak yen tailwinds, AI demand spillovers, and ongoing governance reforms.
Dynamics on the Japanese yen remain a function of multiple swing factors. On the macro front, Japan has decisively shifted into a reflationary regime, as driven by firm domestic demand, sustained wage gains, and corporate costs pass-through, reinforcing a more durable inflation cycle. Against this backdrop, the policy mix is becoming more complex: the government is leaning into growth-oriented fiscal support, including targeted industrial investment and proposed consumption tax relief, while the Bank of Japan (BoJ) continues a gradual normalization path after multiple rate hikes since March 2024.
Notably, recent yen weakness looks increasingly driven not just by rate differentials, but also by speculative positioning, limited repatriation, and renewed fiscal sustainability concerns. Even so, this combination of supportive policy, structural reflation, and a weak currency has been a meaningful tailwind for Japanese equities, where earnings momentum remains strong and artificial intelligence (AI)-related capex is providing an additional catalyst.
In the reflationary era
After decades of deflation, Japan has moved into a reflationary phase, driven by firm domestic demand and sustained wage gains following successive Shunto rounds. And while firms have historically absorbed cost increases to protect market share, mounting margin pressure is driving a shift toward more active price pass-through, as indicated by the price pass-through rate from the Ministry of Economy, Trade and Industry’s (METI’s) Price Negotiation Promotion Month follow-up survey, which rose by 3 percentage points to 52.4% from a year ago, and reinforcing a more durable reflation cycle. Recent data suggest that growth is running above potential, underpinned by improving income conditions, a gradual recovery in consumer sentiment, expectations that the oil price shock will fade, and prospective government consumption tax cuts.
Meanwhile, Tankan surveys point to rising corporate confidence, with concerns shifting from weak demand to whether margins can keep pace with higher labor and input costs. Capex intentions remain resilient, supported by structural drivers, including AI investment amid labor shortages and expanding semiconductor manufacturing capacity.
Supportive fiscal stance meets monetary policy normalization
The Takaichi administration is pursuing growth-oriented policies through broader fiscal activism and targeted industrial investment, particularly in supply-chain resilience and AI. Measures include energy subsidies, higher tax thresholds, and a newly announced two-year cut in the food consumption tax rate from 8% to 1%. While supportive for households, these initiatives have revived investor concerns over fiscal sustainability given potential revenue losses and Japan’s elevated public debt, which in turn could pressure the yen and push long-end Japanese government bond (JGB) yields higher.
As confidence in wage growth and inflation durability has improved, the BoJ has raised rates five times since March 2024. The central bank’s gradual approach has contributed to episodes of market volatility. With the yen still weakening, markets have largely priced in a September rate hike. In our view, the BoJ faces a conundrum. A pause risks perceptions that the monetary authority is falling behind the curve, while a more aggressive hiking path could materially raise government interest costs, even if it helps slow yen depreciation.
Forex, flows, and fiscal fundamentals
USD/JPY’s moves are not fully explained by 10-year bond yield differentials, suggesting other drivers could be at play, such as speculative positioning, limited repatriation, and fiscal concerns.
Net short yen positions had rebuilt to elevated levels last seen in mid-2024, based on CME’s net options and futures contract data. And while recent interventions have similarly sharply reduced short positioning accordingly, the relative economic conditions have been vastly different, with the current robust U.S. economic activity a sharp contrast to the U.S. growth shocks in 2024. As such, current carry dynamics are fundamentally little changed, with the carry trade likely to continue exerting pressure on the yen.
Capital flows also add to the structural currency pressure. Despite a record current account surplus, a growing share of Japan’s income is earned overseas. Persistent yen weakness reduces incentives to repatriate earnings and encourages reinvestment abroad, limiting incremental yen demand. Domestic outflows also remain a headwind: households remain buyers of foreign equities via NISA, and insurers continue purchases of foreign bonds while reducing FX hedge ratios, adding to the currency pressure. That said, as Japanese bond yields rise and eventually stabilize, local investors may turn to domestic markets gradually turn to domestic markets instead.
Fiscal concerns are also showing up in price action: since late last year, USD/JPY has become negatively correlated with long-end yield differentials as yen weakness coincides with higher relative long-end yields. This reflects that, while the administration advocated for a “responsible proactive fiscal policy” stance, markets have been less optimistic and remain focused on the risks of continued fiscal expansion without credible consolidation plans. This has thus amplified the yen’s weakness further due to concerns about fiscal sustainability and debt dynamics.
Equity market tailwinds and investment implications
An expansionary fiscal policy and still-accommodative monetary conditions have supported Japanese equities, with MSCI Japan and TOPIX up 22% and 18%, respectively (Exhibit 2), outperforming most developed peers. A weaker currency was also favorable for export-oriented Japanese corporates, with a deepening correlation between the currency and equity market performance in recent months. Fundamentals also look strong: 2Q earnings grew 60% y/y, as led by both AI-related demand in technology and cyclical demand in financials and industrials, which could extend earnings momentum further. With an average of +27% earnings surprise and where 74% of reported companies exceeded analyst estimates, this suggests Japanese earnings strength is broad-based and that market expectations still lag this fundamental upcycle.
Other longer-term support also remains intact. With the ongoing corporate governance reforms, announced share buybacks have surged to JPY 12.7trillion fiscal year to date, up from the JPY 10.9trillion for the same period last year and on track for another record year. Along with sustained wage growth, improving domestic demand, and a structural reflation, these continue to support a constructive backdrop for Japanese equities in both the short- and long-term horizon.