Why Japanese equities are weathering the storm

If the past few years have taught investors anything, it’s that geography doesn’t insulate you from global shocks. Japan, like Europe and the UK, is highly exposed to the ongoing energy crisis, relying heavily on imports to keep its economy moving.

With over 90% of its oil sourced from the Middle East, Japan sits squarely in the line of fire if tensions continue. Add in a market tilted towards energy-intensive manufacturers and exporters, and the risks are clear: higher input costs, margin pressure and vulnerability to currency swings.

Yet, despite these headwinds, Japan still has much to offer investors.

A more supportive growth backdrop

Japan’s domestic story has quietly improved and forward-looking economic indicators such as the PMIs, which measure the outlook for both manufacturing and services sectors, have held up better than in other regions such as Europe, despite the ongoing global energy crisis.

Importantly, these improvements in Japan’s growth are being reinforced by policy. The government’s ongoing $135 billion stimulus packages, including targeted subsidies and tax cuts to cap household energy bills and support smaller businesses, have helped cushion the impact of global price shocks while preserving consumption. At the same time, the government has been injecting funds into new initiatives, which are encouraging wage growth and investment.

We’ve also seen the fruits of coordinated policy between government and business in Japan. Each year in the spring, labour unions and businesses enter negotiations of wages, called ‘shunto’ negotiations. Recently, these shunto negotiations have delivered some of the strongest pay rises in decades for union members (at over 5% in each of the past three years), supported by government pressure on corporates to share profits more evenly. That, in turn, had fed into higher real wage growth and consumption before the Iran war, helping shift Japan’s growth model away from pure exports.

Corporate Japan is finally changing

Perhaps the most important shift is structural. The Tokyo Stock Exchange’s reforms, particularly its push for companies trading below their underlying book value to improve capital efficiency, are having real impact. Firms are increasingly being called out and required to publish plans to lift valuations, creating a step change in accountability.

This sits alongside broader governance reforms, which are actively encouraging independent directors, better disclosure and decision-making that’s focused on shareholders (investors).

The results are becoming visible. Companies such as Toyota and Sony have stepped up share buybacks and capital allocation discipline. Cross-shareholding (where different companies buy and sell shares of other companies), once a hallmark of corporate Japan, are also unwinding, freeing up capital.

Balance sheets remain a key advantage. Large cash reserves and low leverage (traditional traits of Japanese companies) could now be deployed more efficiently going forward, whether through investment in automation and AI or improved payout policies.

These corporate reforms have meant Japanese stocks’ returns on equity, which shows how efficiently a company uses shareholders’ investments to generate profit, have been improving at a rapid rate since the start of the decade. Currently, the rates of improvement relative to history are beating other developed markets.

Stronger fundamentals, better momentum

Japan is also improving rapidly from a low base when it comes to earnings, and momentum is firmly on its side. Earnings growth has been solid for much of the past year and earnings breadth (the number of upward revisions minus downward revisions relative to all companies in the market) is beating most other developed market regions, even in the wake of the energy crisis (see below). Meanwhile, profitability metrics such as margins have also continued to be stable.

Valuations add another layer of support. On a sector-neutral basis, Japanese equities still trade at a discount to its long run averages going back to 1994, while other regions look more expensive on this basis. Solid earnings growth so far this year has helped keep Japan’s valuations in check.

Finally, the yen has been weak recently which supports Japanese companies’ earnings should it continue, since a weaker currency makes Japanese exports look cheaper to foreign buyers. However, although a stronger yen from possible currency intervention in the near term could offset these effects, appreciation could also boost purchasing power domestically and enhance returns for overseas investors. These dynamics could become more relevant if policy normalisation (through planned BOJ rate hikes) continues. In any case, currency movements in both directions could be seen as supportive.

The key risk: energy and geopolitics

The near-term outlook, however, hinges on geopolitics. Japan’s dependence on Middle Eastern energy is a critical vulnerability. Any sustained disruption, particularly a closure of the Strait of Hormuz, would quickly feed through into higher input costs and create a more challenging environment for company earnings, especially for industrials and manufacturers.

For a constructive short-term view on Japanese equities, tensions involving Iran need to stabilise. Without that, the energy shock risks overwhelming an otherwise improving fundamental story.