In brief

• The Japanese equity market has been boosted by the corporate reform story, but there are other factors supporting the outlook.
• The “virtuous cycle of prices and wages” appears on track to help lift domestic demand.
• Fiscal policy is increasingly supportive and monetary policy normalization will proceed slowly, limiting negative impact.
• Geopolitics is a headwind for a cyclical economy like Japan but is somewhat mitigated due to offshoring much of production.

Last year, Japanese equity performance benefited from corporate reform initiatives aimed at enhancing governance and shareholder value. As previously noted, these programs have achieved some success, leading to increased dividends, a rise in stock buybacks, reductions in cross-shareholdings, and improvements in return-on-equity and price-to-book ratios across Japan's benchmark indices. However, these corporate reforms are ongoing, and while initial data shows positive results, the long-term impact will continue to unfold over time. This is a positive development, but solely relying on a long-term story to carry the Japanese equity market may not be sufficient.

Japan does have other drivers beyond the focus on corporate reform measures. One key positive for Japan is the return of reflation through wage growth, which could potentially lead to a sustained increased in consumer spending, or the Bank of Japan’s aim of a “virtuous cycle of prices and wages”. Although current wage growth is modest, real wages are still expected to rise in 2025, which should lead to boosting domestic consumption and in turn, Japan’s growth prospects.

We believe the decent corporate earnings result and higher inflation expectations in Japan this year will continue the wage increase trend next year. Wages are typically negotiated annually in the spring during the "Shunto" discussions between corporate management and labor unions and are heavily influenced by last year’s inflation rate. It will be key to watch the size of the wage hike results, but current developments lean to the positive.

In terms of the local political landscape in Japan, the story is mixed. Concerns about the stability of the Ishiba Administration persist due to its limited negotiating power both domestically and internationally. A minority government after the disappointing election results, the administration is expected to seek cooperation from opposition parties, such as the Democratic Party for the People (DPP), to gain stability for implementing fiscal stimulus policies.

Exhibit 1: Improving wages leading to higher consumer spending could finally spell the end of deflation
Seasonally adjusted, year-over-year change

Source: Cabinet office of Japan, FactSet, J.P. Morgan Asset Management. Data are as of December 2, 2024.

The government's new economic package focuses on tackling inflation, which has been a key concern for consumers. The announced stimulus plan is slightly larger than last year’s, and is likely to have a positive impact on the Japanese economy. Key pillars of the stimulus plan are aimed at addressing the rising cost of living and providing a sense of security. The package totals Japanese yen (JPY) 21.9trillion in fiscal outlays, with a FY24 supplementary budget of JPY 13.9trillion, aligning with Prime Minister Ishiba's pledge for a larger extra budget compared to last year's JPY 13.1trillion. With private sector financing included, the total package size reaches JPY 39trillion. The government expects this package to boost real gross domestic product by approximately JPY 21trillion and increase the growth rate by about 1.2%. Of key interest is the extent of personal tax cuts, such as raising the annual earnings threshold for income tax from the current JPY 1.03million. This adjustment in income tax brackets could prompt more part time workers to work longer hours, since the corresponding rise in income could still be exempted from income tax. This could bring higher labor supply and contribute to economic growth.

The Liberal Democratic Party’s (LDP) weak election showing has increased pressure for more permanent tax cuts and populist measures. Opposition parties like the DPP have made expanding tax deductions a condition for supporting the FY2025 budget proposal. Ishiba and the LDP is expected to partially accommodate these demands, which means a likely stalling in the momentum for fiscal consolidation and reducing government debt levels, at least temporarily.

On the monetary policy front, the Bank of Japan’s (BoJ’s) path towards normalization remains influenced by U.S. economic conditions and exchange rate trends. Much of the JPY movement is due to interest rate differentials. We think the BoJ will still aim to slowly move to a 1% policy rate and try to stop excessive JPY depreciation. From 2022-2023, the relationship between JPY strength and equity performance was weak. However, it has recently shifted back to a strong negative correlation, suggesting a weak JPY is still helpful for equity performance. Despite the short-term support to equities from JPY depreciation, the BoJ is likely to take issue with a too weak JPY causing imported inflation and depressing domestic activity.

One major uncertainty Japan faces is the trajectory of regional trade amid rising U.S.-China trade tensions. In addition to the direct negative impact on Japan from tariff increases by the U.S., a key trading partner, the intensification of U.S.-China trade friction could indirectly harm the Japanese economy and industries such as the semiconductor sector through a downturn in the Chinese economy.

During Trump’s first term in 2018, many Asian exporters shipping parts and components to China for re-export to the U.S. were directly affected by tariffs on China. There will be some negative impact, but it will unlikely match worst case scenarios as Japan has shifted to offshoring much of their production and manufacturing much of their goods in the markets where they sell them, instead of in Japan.

Investment implications

Our overall outlook on the Japanese equity market is still positive, and we see supportive factors beyond the story of the corporate reforms pushing for greater shareholder value. The wage and reflation support is one of the strongest factors for a growing economy, while government support factors are more uncertain but still lean toward positive. Normalization of interest rates is a minor concern in our view. Even if the BoJ continues to raise its policy rate in the future, we believe that the accommodative environment should persist, limiting the potential for significant negative impact on Japanese equities and the economy. Trade issues should see only limited negative impact from U.S. tariff and regulation changes. The investment case for Japan is still strong with Japan’s earnings outlook generally positive with a growth of around 7% for 2025, and valuations are undemanding, with price-to-earnings ratios being close to average.

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