The underlying strength of Japan’s economic recovery, driven predominantly by the private sector, remains robust.
Analysing Japanese equities while living in Tokyo, I've had a front-row seat to witness the country’s economic saga, spanning nearly 30 years of low inflation and deflation.
During this period, Japan has cultivated companies capable of growing sales, profits and market capitalisation at rates significantly outpacing the national economy. Toyota, for example, sells 10m cars annually, only 1.5m of these in Japan. Toyota epitomises global reach and adaptability of Japanese companies.
Historically, Japanese equities have been perceived as a cyclical asset class, offering little incentive for long-term investment. However, with nominal GDP rising to new highs above Y600tn ($3.9tn), Japan stands at a critical juncture. Despite looming local political and geopolitical uncertainties, underlying strength of economic recovery, driven predominantly by the private sector, remains robust.
Since 1998, corporate Japan's profit margins have improved significantly. Ministry of Finance data shows ordinary profits (excluding financials, insurance and large firms) have risen to almost 11 per cent, nearly triple the historical range since 1970. This has been achieved through long-term cost suppression measures, including wage and capital expenditure restraints. As a result, balance sheets have become extremely healthy but accumulating large reserves of underutilised capital.
Imagine an ecosystem full of companies and consumers that, for years, have been cutting costs with little incentive to invest. That is Japan. Now, under a moderately inflationary regime, with the Bank of Japan raising previously negative policy rates and improving corporate governance, this capital is being redirected into higher-return projects and, when share prices are undervalued, back to shareholders.
Japan’s listed companies have grown earnings at 10 per cent annually over the past decade, driven predominantly by manufacturing productivity gains. Sectors related to IT, including electrical machinery, electronic devices, components, and information and communication-related equipment, have all seen significant productivity gains.
However, Japan remains at full employment, even though women and elderly workers have re-entered the workforce. As new demand from increasing tourist numbers feeds through, domestic service sectors face challenges to deflation-era business models relying on inexpensive labour.
Walking through Tokyo’s bustling streets, as well as rural areas, one sees changes firsthand. Service sector companies are increasing capital expenditure, driving economic dynamism as the economy slips into supply-side tightness few would have imagined. In response, pricing behaviour is changing, toning down excessive service levels and modifying business models, to drive productivity growth as companies innovate and exit the market.
Labour shortages
The once weak gravitational pull of economic and market forces is now acting differently on Japan's deflationary equilibrium. During the Abenomics era (2012-2015), corporate profits were insufficient, necessitating policy-driven interventions. The three arrows of Abenomics — monetary easing, fiscal stimulus, and structural reforms — aimed to revive Japan's stagnating economy. While these policies had varying degrees of success, today’s growth is more driven by private sector dynamism than government intervention. The end of private sector downsizing and changes in the global inflation environment are primary drivers of economic change.
Rising private sector wages are a key driver of Japan's economic growth. The country's ageing population and declining birth rates have led to labour shortages, driving wage increases and productivity improvements across various industries. But it’s necessary to keep an eye on the “transmission mechanism” from wages to prices, compared to other developed economies.
The Bank of Japan estimates basic wage growth of 3 per cent —achievable with nominal wage growth of 5 per cent — is necessary for a sustainable positive cycle of prices and wages.
In 2024, “Shunto” — agreed major union wage increases — reached 5.1 per cent, surpassing the 5 per cent target and marking the highest level in 33 years. For 2025, there is already a push towards achieving wage increases above 5 per cent, with higher levels expected in 2026 and 2027. At this level, continued economic growth driven by private sector dynamism is expected as firms and consumers adapt to rising prices and wages.
Political uncertainty
As the positive cycle of prices and wages takes hold, the recent Lower House election has rendered the political landscape more fluid, causing the ruling LDP-Komeito coalition to lose its lower house majority for the first time in 15 years.
Unrest among the electorate centres on political funds fraud allegations within the party and unease about pressure of rising prices on the most economically vulnerable.
Prime minister Shigeru Ishiba has declared his intention to cooperate with opposition parties. Policy direction involves: further strengthening political funding regulations; fiscal stimulus focusing on households; and gradual interest rate hikes by the Bank of Japan, contingent on continued wage increases and financial market stability, though at cautious pace considering opposition claims.
In the near term, duties of the Lower House will include formulating the supplementary budget. There is significant risk for potential policy mistakes to push the country back into deflation, stemming from monetary or fiscal missteps, most likely from short-termism in policy making.
For instance, during the Abenomics period, the government, eager to declare victory over deflation, explicitly targeted raising inflation to 2 per cent within two years but prematurely hiked consumption tax, stifling price growth and reigniting the deflation mindset. Ensuring monetary and fiscal policies are well-coordinated is crucial to maintaining economic stability.
Despite political uncertainties and an ageing population, Japan's economic momentum appears strong enough to weather potential storms and testifies to resilience of its private sector. The country has managed to cultivate a robust economic environment driven by corporate innovation and strategic investments.
While challenges remain, the foundation for long-term growth is strong, offering a compelling narrative for investors and stakeholders alike.
Alexander Hart, Japanese equity specialist, Sumitomo Mitsui DS Asset Management
