Why Japanese equities still offer compelling opportunities

Japanese equities have delivered strong performance year-to-date, with the TOPIX up 13.0%¹ in JPY terms, despite navigating a complex backdrop of geopolitical tensions and currency volatility. While the broader Japan market has undergone multiple years of strong returns and re-rating, opportunities persist for active investors. Buoyed by structural tailwinds such as corporate governance reforms, improving capital efficiency and a gradual recovery in domestic demand, the medium-term outlook for the Japanese equity market remains constructive. However, we believe it has become more important to take a selective approach in the current momentum-driven market in order to generate returns.

The latest estimates suggest Japan has around 8 months of strategic plus commercial oil reserves, which provides a buffer against near-term supply disruption². However, with the Middle East accounting for 95% of Japan's crude oil imports, import costs of oil and other materials will increase if the Strait of Hormuz continue to stay closed. While some of these costs can be passed through to end users and households, there will be impact on corporate earnings, with downstream oil and transportation-related industries likely to be the most vulnerable.

Crucially, Japan’s fiscal position has improved in recent years as net debt to GDP declined post-COVID on the back of reflation and decent economic growth. Strong corporate profits have also boosted tax revenues. Meanwhile, low interest rates have kept debt servicing (interest payments as % of GDP) manageable versus other developed countries. This gives the Takaichi administration some fiscal capacity to cushion the shock for consumers, as evidenced by the latest supplementary budget which was focused on cost-of-living measures.

The BoJ’s Monetary Policy Meeting in April reflected a more divided board, with 3 members voting for a rate hike. Higher energy and input costs arising from the prolonged US-Iran war have led the BoJ to raise their inflation forecasts. Yen weakness has also increased imported inflation pressures. Together, these factors have lifted expectations of a rate hike in June or July.

We do not expect the rate hike to have a material impact on the Japanese equity market. With real rates still near zero, incremental rate hikes are unlikely to increase interest payments significantly for most companies.

The yen has faced sustained downward pressure over the past three months as elevated oil prices have boosted demand for US dollars to meet higher energy import costs, increasing selling pressure on the yen.

The Ministry of Finance had intervened at the end of April and in May when the USDJPY was around 160. As with most currency interventions, the impact is likely to be temporary unless there is a material change in the macro backdrop. Most notably, oil prices would need to fall for the selling pressure on the yen to ease.

On the regulatory front, the Financial Services Agency and the Tokyo Stock Exchange have recently proposed revisions aimed at incentivizing companies to deploy the hundreds of billions in cash on their balance sheets.

We have observed this reform momentum across our portfolio; plans to enhance capital efficiency and shareholder returns have been announced across our holdings in the autos, retail, insurance, chemicals, industrials and technology sectors. In the broad market, dividends and buybacks have shown little sign of slowing down.

We had increased our exposure to a number of underperforming technology stocks in the second quarter of 2025 during the US tariff drawdown, which subsequently outperformed this year. This contrarian approach was especially rewarding since we had chosen not to chase the more crowded AI trades, which remain at stretched valuations. Our Financials exposure also performed well as ongoing interest rate normalisation supported the banks’ net interest margins, and strong corporate borrowing boosted their loan books and overall profitability. Our active stock picking approach also proved effective as selected stocks in construction, pharmaceuticals and auto parts generated alpha.

We turned more cautious on our chemicals and materials holdings after strong performance in January and February. This proved timely, as a number of them have meaningful exposure to petrochemical input costs, making them vulnerable to the current geopolitical tensions.

Rather than trying to anticipate how the US-Iran war would evolve, we have stayed true to our process of trying to find undervalued opportunities. We rotated into more defensive and domestically oriented names, including select companies in healthcare, medical equipment, and consumer services, which present more appealing entry points and greater alpha potential in less crowded market segments.

Beyond the defensive and domestic names mentioned above, we are positive on Industrials, as the broader capital expenditure cycle for automation names has turned increasingly positive since Q4 2025.

We are carefully monitoring our technology exposure given the sector's robust performance. Some of our key investments are attracting increased investor interest, with market sentiment turning bullish rapidly. While the capex and earnings momentum in AI-related industries remain strong, we are taking a more cautious approach and prefer not to chase valuations. On the other hand, the software sector may present interesting opportunities given its recent underperformance.

We believe that it is important to remain diversified in terms of alpha and risk sources, especially in a market with narrow leadership. Instead of relying on a single trend or narrative, our investments are supported by various drivers including AI, wage and reflation normalisation, continued capex upcycle, corporate reforms, cyclical recovery, and idiosyncratic events.

Recent unexpected macro and geopolitical developments reinforce the importance of an investment approach that is anchored in fundamentals and valuations for greater portfolio resilience. We stay true to this active approach and remain constructive on the outlook for Japanese equities over the medium to long term.