After tariff deal, Japanese resilience remains

Japan’s recent moment as the darling of global equity investors looked like it would be relatively short-lived. The meteoric rise experienced in late 2023 and the first half of 2024 seemed to unwind with the end of the yen carry trade, followed by a significant dip on the Nikkei 225 after the announcement of significant US tariffs as part of President Trump’s ‘liberation day’ in April. After a trade deal was reached, applying blanket 15 per cent tariffs to Japanese exports and mandating hundreds of billions in Japanese investment into the US, Japanese equities resumed their upward trajectory.

While an equity market might not completely display a country’s economic fortunes, in the case of Japan it hints at an economic engine that might have coughed and spluttered a bit, but is now back to chugging along. Anne Vandenabeele, Economist at Capital Group, explained why she believes the narrative of reflation and corporate governance reform, that prompted Japan’s resurgence in the eyes of investors, remains intact.

“The reflation story has taken a little bit of a pause, or maybe a bit of a step back. There are clearly some risks, but I would say there are three or four things that still give me some conviction that we will see reflation in Japan over the medium to long-term,” Vandenabeele says.

She identifies tariff certainty, demographics, investment in efficiency, and central bank policy as factors keeping the Japanese outlook positive.

Tariffs, Vandenabeele notes, are certainly a hit but the Japanese economy remains somewhat resilient and some of its largest exporters, notably the automakers, have capacity to absorb some of these hits. Domestic demand may be somewhat fragile, but it is not so weak as to be existentially damaging for Japanese companies.

Longer-term, Vandenabeele says that demographics continue to drive the reflation narrative. A shrinking labour pool as the population ages is creating incentives for workers to seek higher wages. That has created a degree of inflationary momentum which has, in turn, prompted companies to adapt and become more efficient. That has manifested in higher capital expenditures as well as investments in digitization and corporate consolidation along with shifts in governance incentivized by government, foreign investors, and domestic business leaders.

The final piece supporting the Japanese picture, Vandenabeele says, is a Bank of Japan (BoJ) that sees reflation as the path forward for Japan. She notes that the BoJ is seeking to walk a tightrope between rate increases, the maintenance of the yen, and a focus on positive inflation.

For investors, that reflation means a rerating of equity valuations. Higher nominal growth as a product of higher real growth and inflation points to a more normalized market environment. That trend, in addition to the improvements in corporate governance, might result in the return to a market that resembles normalcy and dispels the last skeptical hangovers from the bursting of the Japanese asset bubble. Moreover, Vandenabeele notes that foreign investors might take some short-term weakness on the back of tariffs as an incentive to participate in this longer-term story.

That is not to say Vandenabeele sees Japan as risk-free. She notes, for example, a degree of political risk emerging in the leadup to and fallout from Prime Minister Shigeru Ishiba’s resignation as leader of the coalition-leading LDP. Vandenabeele notes that Japan has struggled with weak coalition governments over recent years and that the latest political shift opens up potential risky avenues. That might involve a more conservative pivot with the LDP taking a more anti-immigrant stance, which could be less economically advantageous. There could also be more political pressure to keep interest rates low. There could also be the possibility of a more pro-growth leader emerging in Japan, which might be more of a political risk to the upside for Japanese equities.

In addition to domestic politics, Japan’s agreement to invest $550 billion over three years in the United States might come with some serious implications. That sum of money is equivalent per year to the value of Japan’s US exports, and the structure of the deal comes with lopsided profit sharing, potentially limited upside, and challenging optics for Japan. Should Japan re-neg on that deal, tariffs could be imposed at higher rates and the Japanese economy might be at greater risk again.

Vandenabeele also sees a risk that the BoJ capitulates or takes too cautious of a line with its rate policy. The symbolism of a central bank that has given up on normalizing rates could derail FX markets and see the yen depreciate again. Despite all these risks, she sees a picture of broad resilience in Japan.

For Canadian investors now looking at Japan, Vandenabeele says that the country’s emergence from a period of constant stagnation will see a new set of winners and losers emerge. FinTechs, domestic focused companies, and consumer-oriented companies may set the tone on equity markets, rather than exporters. Japanese startups are emerging, too, with success in areas like space exploration. Vandenabeele argues that in this environment, an active and bottom-up approach can prove advantageous in accessing upside in an enormous market.

“It is a huge market with world class companies, so you do want exposure to it. And it's also a market where investors go through phases of focus and defocus,” Vandenabeele says. “Periods like now where things are a bit down, but not out, these are times of opportunities. I think it would be a mistake to ignore it.”