2025 is the year to stay bullish on Japan

YEAR-TO-DATE, Japan’s Nikkei 225 Index has been on a record-setting run and has returned nearly 20 per cent. This rally has been fuelled by a series of positive earnings reports – particularly from the nation’s three megabanks.

In fact, the top financial institutions have emerged as standout performers – with record earnings – as the Bank of Japan’s (BOJ) monetary tightening drove higher net interest margins.

This performance highlights the profound changes that are underway in the country’s economic and monetary landscape. For example, the central bank’s interest rate hike in March – the first in 17 years – appears to have put three decades of deflation decisively behind the country.

This has not only bolstered the banking sector, but also reinforced investor confidence that Japan is moving away from its “Lost Decades”.

Japan as a strategic allocation in portfolios

We believe that Japan deserves a long-term strategic allocation in investors’ portfolios. Improving fundamentals and ongoing economic normalisation make the country a compelling investment destination for those seeking growth and diversification.

The economy is going through a period of structural transformation from deflation to inflation. Price increases are now on a par even with other major economies such as the US and the European Union.

The core consumer price index has now remained above the BOJ’s target of 2 per cent for more than two years, with the October inflation print rising 2.3 per cent from a year earlier.

Continued wage hikes, as a result of inflation, will boost households’ purchasing power and keep the economy strong, driving a virtuous circle between wages and prices.

Japan’s largest labour union group Rengo has announced that it will seek wage hikes of at least 5 per cent in 2025, mirroring this year’s hefty increase.

It also stated that it will focus on securing higher wage increases at smaller companies – which employ the majority of Japan’s workers – with a target of at least 6 per cent to help narrow the income gap with workers at large companies.

Meanwhile, UA Zensen – another major union group – will seek a bump of 6 per cent in overall wages.

Besides inflation, structural reforms aimed at promoting capital efficiency and shareholder returns are gradually fostering an environment conducive for growth.

The country’s commitment to corporate governance reforms has started to bear fruit, as companies increasingly prioritise shareholder returns.

As at end-October 2024, 88 per cent of companies listed on the Tokyo Stock Exchange’s prime section have responded to calls to enhance capital efficiency.

This paves the way for more dividends, share buybacks and greater transparency in management practices, making Japanese equities more attractive on a global scale.

Bright earnings prospects

Looking ahead, we also see the potential for the Japanese yen to appreciate, on the back of narrowing yield differentials against the continued divergence of monetary policies between Japan and the rest of the world.

Historically, the Nikkei 225 tends to have a positive correlation with the US dollar-yen exchange rate, due to the export-oriented nature of many Japanese companies. This means that a weaker yen often coincides with a stronger Nikkei 225, and vice versa.

While the yen may strengthen, we believe that corporate earnings will remain well-supported, delivering double-digit growth. This is underpinned by the global competitiveness of Japanese companies and key megatrends such as digitalisation and artificial intelligence (AI).

Besides, a stronger yen reduces the cost of importing raw materials, which can offset some pressure on earnings – particularly for smaller companies, which are typically domestically oriented.

Turning to the bigger picture, Japanese companies have long been recognised for their innovation, quality and operational efficiency.

The technological leadership of companies ensures sustained demand regardless of short-term currency movements.

In our view, the IT sector – the largest in the Nikkei 225 – is positioned to drive forward earnings growth, fuelled by strong global demand for AI.

Take Advantest, the world’s biggest supplier of chip-testing equipment. In the three months ended September, the company reported a near two-fold increase in net income. It achieved a record high for the quarter, driven by robust tester demand for high-performance semiconductors used in AI.

Even though the management assumed a stronger yen against the US dollar, earnings guidance has still been revised upwards.

This is because strong tester demand for semiconductors related to AI and high-performance computing is expected to continue, with chips growing in importance in the global economy.

We expect IT to play an increasingly pivotal role in both the economy and stock market.

Prime Minister Shigeru Ishiba has recently pledged more than US$65 billion of fresh support for the nation’s semiconductor and AI sector, underscoring Japan’s ambition to reclaim its status as a global semiconductor leader.

Notably, this has led to the impending listing of memory chipmaker Kioxia on Dec 18.

The initial public offering is among the largest in Japan this year. It will enable the company to ramp up capacity and stay competitive in the capital-intensive memory chip market.

Sustained rally

In a nutshell, we find compelling reasons to stay bullish on Japan in 2025.

Structural factors such as the move towards sustainable inflation, strengthening wages and ongoing reforms to improve capital efficiency will breathe new life into its economy and stock market. This paves the way for a sustained, multiyear rally.

The aftermath of the “Lost Decades” may have caused many foreign investors to be underexposed to Japanese equities.

Now is the time to reconsider this stance.

Beyond being a top travel destination, Japan warrants a long-term strategic allocation in investment portfolios.

Its equity market also offers access to some of the most dynamic and innovative companies of the global economy, providing opportunities for diversification and growth.

The writer is an assistant manager with the research and portfolio management team at FSMOne.com, the B2C division of iFast Financial, a subsidiary of iFast Corporation