At a glance
- Japan is undergoing a transformation. With valuations well below historical averages and global peers we see an attractive entry point for investors.
- After decades of stagnation, domestic demand is driving robust nominal GDP growth. With self-reinforcing expansion taking root, the shift is more than a cyclical upturn.
- Corporate governance continues apace – Japanese companies are redirecting underutilised capital and unlocking shareholder value through concrete actions.
- Market inefficiencies give active managers scope to enhance returns by avoiding companies eroding value and uncovering opportunities in a market with limited analyst coverage.
Japan is undergoing a transformative moment that positions it as one of today’s most compelling investment opportunities. The temporary nature of trade tensions stands in contrast with a powerful combination of strong domestic-led growth and sweeping corporate governance reforms that are reshaping the economy. With valuations sitting well below both historical averages and global peers, investors now have a rare opportunity to invest in Japan’s structural transformation.
The great escape: Japan’s nominal GDP and the rebirth of domestic demand
After decades of stagnation, Japan has emerged from its so-called ‘Lost Decades’ with renewed economic vigour. The evidence of this transformation lies in robust nominal GDP growth – notably driven by domestic demand rather than external trade.
This shift represents more than a cyclical upturn. A selfreinforcing ecosystem of growth has taken root. Companies are reinvesting in capacity and productivity, while rising wages are fuelling household consumption. Price stability is supporting
steady domestic expansion, complemented by sustained strength in corporate earnings.
Figure 1: TOPIX-GDP Alignment: Japan‘s Market Mirror
Source: Cabinet Office, Morgan Stanley Research. TOPIX (pt), Japan nominal GDP (trillion yen).e=Morgan Stanley Research estimates.
While higher baseline US tariffs pose potential headwinds for exporters, Japan’s economic base has shifted meaningfully toward domestic engines. Moreover, companies with established pricing power have demonstrated their ability to effectively manage cost pressures through price adjustments.
Most telling is Japan’s ability to maintain its growth trajectory despite significant challenges – domestic political shifts, Bank of Japan (BoJ) rate hikes, and US trade uncertainty. In this environment, investors are revaluing Japanese equities with a new lens – one that factors in not just cyclical strength, but lasting structural change.
Capital’s new course: Japan reformed
Corporate governance reform stands as the cornerstone of Japan’s investment transformation. After decades of inefficient capital allocation, Japanese companies are now systematically unlocking shareholder value through concrete actions.
Figure 2: Record share repurchases signal corporate Japan‘s transformation
Source: Factset, Jefferies, Bloomberg. Data as of 16 May 2025.
The transformation extends beyond shareholder returns. Under inflationary conditions and new Financial Services Agency disclosure requirements, companies are optimising their balance sheets – redirecting underutilised capital from cash hoards, real estate, and cross-held equities into productive investments for sustainable growth.
Figure 3: Japan‘s balance sheet revolution
Source; Bloomberg, FactSet, QUICK Workstation, I-N Information Systems, Toyo Keizai, Morgan Stanley Research. The universe is TOPIX 500 excluding financials. Underutilised capital includes cash and deposits, cross shares, pure investment shares, and real estate.
Near-term outlook: strength amid uncertainty
Recent market volatility masks Japan’s compelling long-term economic transformation. At its core, the economy shows remarkable health, anchored by a robust labour market and rising wages that continue to fuel domestic consumption. These domestic drivers provide natural insulation against current trade uncertainties.
While the timeline for a trade resolution with the US remains fluid, Japan’s strong negotiating position suggests these tensions are transitory rather than structural. A flexible offshore production network, combined with targeted concessions across agricultural imports, defence procurement, and energy investments, provides clear paths toward agreement.
The impact of tariffs on corporate earnings appears manageable, and we continue to focus on companies with established pricing power in our portfolios. Most affected holdings indicate they can effectively manage tariffs through price adjustments, suggesting limited earnings vulnerability. While some temporary caution in capital expenditure is evident, this appears more a matter of timing than structural concern.
Given these conditions, the BoJ is expected to proceed carefully, with any further rate adjustments in 2025 contingent on trade developments. With inflation now embedded in both the economy and the corporate mindset, we do not expect policy normalisation
to derail growth momentum.
Current market softness has created attractive entry points, with Japanese equities trading at compelling valuations versus both historical averages and global peers, particularly on a price-tobook basis. As trade discussions progress and macroeconomic uncertainty subsides in the second half of 2025, investors should
increasingly recognise Japan’s fundamental strengths, including its established inflation dynamics and healthy domestic demand.
The great rotation: Japan’s moment
The era of ‘American Exceptionalism’ in market returns appears to be approaching an inflection point after a remarkable 15- year run. While US equity markets have rightfully commanded premium valuations due to superior earnings growth and thematic leadership, current market dynamics suggest a potential shift in this narrative.
The current US administration’s pivot toward deficit reduction and fiscal restraint marks a decisive break from previous expansionary policies, when stimulus levels matched wartime spending during peacetime. This stimulus has driven private sector growth and shaped market valuations. As fiscal policies tighten, questions around the sustainability of exceptional growth rates may impact investor confidence and valuation multiples.
As US dominance moderates, Japan emerges as a prime beneficiary of this shifting landscape. The market presents a compelling investment case: structural reforms enhancing shareholder value, a deep universe of high-quality companies
capable of sustainable earnings growth, and a mature market infrastructure comparable to the US. This combination of corporate transformation and potential multiple expansion, backed by strong institutions, positions Japan as an increasingly attractive destination for global capital.
Figure 4: Japan’s indices return over the past 10 years has been driven by earnings growth
Source; Bloomberg, FactSet, QUICK Workstation, I-N Information Systems, Toyo Keizai, Morgan Stanley Research. The universe is TOPIX 500 excluding financials. Underutilised capital includes cash and deposits, cross shares, pure investment shares, and real estate.
The bottom line: Japan’s moment for structural re-rating
Japan presents a rare moment where corporate reform, economic stability, and attractive valuations converge. At the heart of this transformation lies unprecedented change in corporate behaviour. The surge in strategic reorganisations, record shareholder returns, and systematic balance sheet optimisation demonstrates Japan’s commitment to capital efficiency. With return on equity (ROE) expansion potential through the activation of underutilised assets, the path to value creation is both clear and measurable.
This corporate evolution is supported by robust economic fundamentals. A self-reinforcing cycle of wage growth and domestic demand has established resilience to external shocks, while current market uncertainty – particularly around trade discussions – appears to be masking rather than reflecting Japan’s underlying strength.
The gap between market perception and fundamental reality creates a compelling entry point. With valuations at historic discounts, investors can now access Japan’s transformation at a favourable price. As global investors reassess US equity market exposure, Japan stands uniquely positioned to capture this reallocation of capital, offering a deep universe of high-quality companies in a mature market framework. Now is the time to look at Japan – not as it was, but as it is becoming.
