Japan's reflation story: An overlooked equity opportunity?

With the regime shifts in Europe and the US cornering so much of the conversation about the global economic landscape, the structural shift in Japan has largely gone unnoticed beyond its own region.

However, this is a story worth paying attention to. After decades of deflation and weak growth, Japan is finally seeing an acceleration in nominal growth. Inflation has broadened, wages are rising, and both companies and households are shedding their deflationary mindsets. Fiscal stimulus, easy monetary policy, and shifting demographics support these trends, which, taken together, point to a more durable nominal growth regime.

For equity investors, the implications of this are significant — and encouraging. In this piece, I explore how investors should think about Japanese equities and detail the investment implications.

Understanding the Japanese reflation story

Nominal GDP growth has been accelerating in Japan since 2022, reversing decades of stagnation. This upturn has come about thanks to a rare alignment of four dynamics:

• Inflation: After decades of weak price growth and an attendant deflationary drag, inflation has accelerated. There are three reasons why. First, demand has recovered following pandemic-induced declines in consumerism. Second, rising commodity and energy prices have passed through into domestic costs. Finally, and most importantly, Japanese corporates have begun to pass on costs to consumers after long-held reluctance to raise prices — a major shift in corporate pricing behavior.
• Currency depreciation: In 2022 – 2023, the Japanese yen depreciated as interest-rate differentials with the US and Europe widened. This boosted nominal GDP because a weaker yen inflated the value of exports and foreign income. This reinforced the pass-through of global price increases.
• Policy: Fiscal support for households (e.g., energy subsidies) has helped Japan maintain spending power despite real income erosion. The Bank of Japan has successfully kept the yield curve in check and introduced a negative interest-rate policy to keep borrowing costs low and credit conditions loose. We expect to see additional fiscal stimulus going forward.
• Corporate profitability: Record profits have emboldened firms, leading to the strongest base pay hikes in 30 years. These wage gains flow directly into nominal GDP via household income and consumption.

This reflation story suggests an auspicious narrative for Japan’s corporate earnings landscape and long-term debt sustainability.

Why this matters for equity investors…

The reflation story, which could underpin a multiyear rerating of Japanese equities, has driven nominal GDP growth higher. This is important not only for bond markets, but also for equity investors for two key reasons:

Nominal growth drives equity returns

Japanese corporates benefit directly from stronger nominal GDP growth. Companies in Japan are well positioned to translate growth into earnings gains and better margins, which would benefit Japanese equity investors.

What’s more, deflation or low inflation tends to compress equity valuations. Now that we’re in the throes of a Japanese reflation, the valuation outlook is improving as earnings become more predictable. This could result in structural reratings that would be a boon for Japanese equities.

The higher nominal GDP growth backdrop also supports household portfolio rebalancing. Traditionally, Japanese households have held half of their assets in cash and deposits, and only about 13% in equities. Stronger growth and modest inflation, like we’re seeing now, erode the real value of cash, making deposits less attractive at the same time equities are beginning to look more appealing.

Add to this mix supportive policies, including an expanded government-supported tax-free investment account program, and the stage may be set for cash to move from the sidelines into the equity market.

Corporate governance reform improves quality

The ongoing corporate governance reforms started by Prime Minister Shinzo Abe address long-standing inefficiencies in capital allocation, corporate management, and shareholder returns — all positives for Japanese equities.

Traditionally, Japanese firms have hoarded cash and maintained cross-shareholdings, depressing returns. Reform policies encourage share buybacks, dividends, and disciplined investment decisions.

At the same time, stronger board independence and disclosure standards have reduced insular decision making among companies, strengthening accountability and transparency. As a result, shareholder value is more highly prioritized, aligning boards more closely with investors (and supporting equity markets).

These reforms are part of a broader, government-led effort to revitalize Japan’s economy by making its equity market more attractive to international investors — an effort that appears to be working. Foreign investment (which was in outflows from 2016 until 2023) has been increasing, which could drive a structural rerating.

…and what they could do about it

The combination of fiscal support and loose monetary policy supports domestic cyclicals. Two sectors that stand out in this area are banks (which have strong earnings momentum and stand to benefit from further interest-rate hikes) and services (which are likely to benefit from those behavioral shifts away from savings I mentioned earlier).

Outside of domestic cyclicals, I believe the companies most dedicated to improving disclosure and governance and eliminating excess cash levels could generate significant alpha for equity investors. Active managers with deep research capabilities and boots on the ground may be better positioned than their passive counterparts to identify the companies that are both:

• Committed to this mission and
• Financially flexible enough to initiate or continue a share buyback or dividend program to pass value onto investors.

The bottom line is, the reflation story in Japan and the nominal GDP growth it encourages appear to bode well for Japanese equity markets, and investors may want to take note.