While an allocation towards Japanese stocks makes more sense today than it did over the last decade, there are a number of risks that temper our optimism…

Japanese equities are back on the radar of international investors. In Q1, Japan’s leading Nikkei Index reached a new all-time high, an accolade that took 34 years to achieve. 

Contributors to this promising performance include a changing macro landscape as Japan moves out of the deflationary doldrums, corporate governance reforms aimed at improving subpar capital allocation, relatively cheap valuations, and a rapidly weakening yen.

We continue to see the potential for Japanese equities to perform well on the back of higher nominal GDP growth and the implementation of corporate reforms. However, investors should bear in mind that current valuations are less compelling than two years ago and that the outlook for a recovering yen looks more like a liability going forward.

Macro improvements

Japan has experienced major macroeconomic shifts since the Covid pandemic. After a decade of dis-inflation – or outright deflation – consumer price index growth has returned to above 2% for the past eight quarters, meeting one of the Bank of Japan’s key monetary policy objectives. The return of inflation has also been reflected in the expansion of Japan’s nominal gross domestic product (GDP). Nominal GDP has increased by 3.5% annually over the last two years, compared to 0.2% annually in the 20 years prior. Exhibit 1 shows that periods of accelerating nominal growth are usually favourable for companies to improve revenues.

While cost pressures prompted the initial rise in inflation, there is hope that it has started a healthier, more sustainable inflation rate in Japan as wage growth starts to accelerate. The preliminary results of the spring (Shunto) wage negotiations brought an average wage increase of 5.28%, above the 5% mark for the first time in 33 years. However, Shunto negotiations cover less than 15% of the Japanese workforce. While wage increases in small- and medium-sized firms were still below inflation, there is hope that workers will be able to command better wages going forward as firms seek to attract and retain talent in an ever shrinking workforce. Moderately better wage growth would be beneficial for overall consumer demand, which would be good news for the sales growth of listed companies – 52% of Japanese firms’ sales are generated in the home market.

A medium-term revival in economic activity may also be supported by manufacturing plants relocating from China, as Western firms look to diversify their supply chains and insulate themselves from a rapidly changing geopolitical landscape. Excellent infrastructure, a high degree of technical sophistication and only moderate labour cost growth over the past 30 years make Japan an attractive destination for high-value added manufacturing companies looking to diversify away from China. A massive drop in the value of the yen – which has lost nearly a third of its value on a trade weighted basis over the past four years – further encourages this relocation.

With an ongoing and hopefully sustained revival in nominal activity, the Bank of Japan has been able to exit its negative interest rate policy. Any further interest rate rises are likely to be modest, but even so, a move towards a positive and upward sloping yield curve should be a tailwind for the financial sector in a similar way to that seen in the US and Europe, where financial stocks have been one of the key contributors to the recent equity rally.

Micro improvements

Much more critical than macroeconomics for positive momentum in Japanese equities are company-specific factors. Corporate governance in Japan has historically lagged international standards, but over the past decade Japan has made incremental changes to improve shareholder value.

Since the introduction of a new stewardship code in 2014, the proportion of companies with a third or more of their board made up of independent directors increased from 6.4% to over 90% in 2022. The recent Tokyo Stock Exchange governance initiative also addressed the need for Japanese companies to improve capital allocation. Currently, 51% of companies in the TOPIX Index have net positive cash balances (Exhibit 2), much higher than in the US (11%) or Europe (13%). This results in a low return on equity (RoE) and lower multiples for Japanese stocks. 22% of companies in the MSCI Japan Index have a price-book ratio of below 1, and 39% have a RoE below 8%. In the US, for example, these shares are significantly lower at 2% and 23% respectively.

The impact of corporate governance reforms is already visible. Both dividend distributions and share buybacks have increased sharply in Japan in recent years, with the volume of share buybacks announced reaching a historical high in 2023. Further reductions in cash levels and the sale of cross-shareholdings to finance share repurchases is expected to improve Japanese companies' future RoE. If companies manage to reduce their cash holdings to levels similar to their European and US peers and continue to disinvest cross-shareholdings, we think the RoE on Japanese stocks could rise to around 12%. Higher profitability is usually rewarded with higher valuations by the market.


While an allocation towards Japanese stocks makes more sense today than it did over the last decade, there are a number of risks that temper our optimism about the ability of Japanese stocks to sustain the pace of recent gains.

First, valuations are not as compelling as they were. At the end of October 2022, at the historical relative performance trough of the TOPIX vs. the MSCI World, Japanese equities traded on a multiple of 12.5 times earnings. By end of April 2024, after a strong rally, the price-to-earnings ratio of Japanese stocks had risen to 16x, slightly above the 15-year average of 15.3x (exhibit 3). We think it is a fair judgment that Japanese equities are not cheap anymore at these valuation levels, which should dampen future long-term return assumptions.

Second, we have concerns about the outlook for the yen and the impact this may have on Japanese stocks. The prospect of lower interest rates in Europe and the US and slightly rising interest rates in Japan should make the yen more attractive as a currency. On a fundamental basis, our latest Long-Term Capital Market Assumptions (LTCMA) paper sees the yen as the most undervalued currency of the major currency pairs.

Given the stable negative relationship between Japanese equities and the yen (Exhibit 4), divergence in the direction of monetary policy between the Bank of Japan and other central banks (Exhibit 5) could provide a headwind for Japanese stocks: the negative earnings per share impact of a stronger yen for export-oriented companies would outweigh the positive impact on domestic companies. However, this dynamic would offer opportunities for active stock selection. More of a focus on domestic companies – usually smaller by market capitalisation – could be beneficial for investors in this case.

Alternatively, if the yen weakens further from its currently low level, Japanese stocks may not see the same currency-related boost as over the past two years. This is because the country could end up facing stronger imported inflation, and in this scenario there is a risk that larger interest rate increases from the Bank of Japan would be required. Sharply higher policy rates, as seen recently in Europe and the US, to reign in inflationary pressures and stabilise the currency are not an option for Japan – this could cause a significant deterioration in the country’s fiscal position, given Japan’s very high net debt to GDP ratio of 158%. A significant rise in longer-term interest rates could also prompt financial stability concerns, due to commercial banks’ meaningful holdings of Japanese government bonds.


Higher nominal GDP growth and credible corporate governance reforms provide a favourable backdrop for Japanese equities. We continue to expect attractive equity returns from region in the medium-term, but higher valuations and currency uncertainty are likely to limit the scale of gains from here. However, a focus on more domestically-oriented and smaller cap companies that could benefit from more sanguine wage growth – and which are less exposed to the risks of a rising yen – could mitigate these considerations and further enhance the return potential of a Japanese equity allocation.

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