Capital Ideas^™ 
Investment insights from Capital Group

Japan has faced no shortage of obstacles of late, ranging from tariffs to intensified calls for new political leadership following a weak result in a recent parliamentary election. Investors are taking the events in stride, with the TOPIX Index near a 40-year high.

Some pressure has mounted for Prime Minister Shigeru Ishiba to resign, even amid securing a fresh trade deal with the U.S. administration. That said, I don’t expect the latest political events to derail Japan’s structural improvements that have made the country a more attractive place to invest.

I anticipate continued progress in automated technologies to address labor shortages, Japan’s push to digitize more of its economy, and the drive by regulators to improve corporate efficiencies, all of which can boost the longer term economic outlook.

Tariff deal helps maintain reflation outlook

I believe the recent trade agreement with the U.S. may improve Japan’s short-term economic outlook and the prospects for sustained reflation after decades of deflation.

My view has been that reflation would continue in Japan as long as three things materialized in the latter half of 2025: lower tariffs, real wage growth and the Bank of Japan’s (BOJ) commitment to monetary policy normalization (end of negative interest rates). With tariffs on exports to the U.S. being less than initially feared, the first of these has occurred.

Interest rate policy: BOJ policy normalization, or the gradual move to abandon its negative rate stance, remains on track and has been occurring gradually. If real wages happen to rebound in the second half of 2025, I anticipate a rate hike before year-end, and a terminal rate near/above 1.5%. Japan’s benchmark rate was 0.5% as of July 31.

Inflation and wages: As for the others, the latest Consumer Price Index data confirms a slowing in cost-push inflation, which is needed for nominal wage growth to catch up and real wages to begin rising. Meanwhile, companies still have capacity to raise wages in 2025 and 2026.

Market underappreciates odds of political change

After overseeing two national election defeats, Japanese Prime Minister Ishiba is under pressure from voters despite achieving a U.S. trade deal. His Liberal Democratic Party (LDP) remains the largest bloc in parliament but now leads a minority coalition in both the Upper and Lower chambers. The party may need to choose new leaders, set policy directions and decide whether to govern as a minority or seek coalition partners.

July’s upper house election result had more impact in fixed income markets, where Japanese 10-year government bond yields rose to their highest levels since 2008 in July. Meanwhile, the yen has weakened in recent months stemming from a combination of monetary policy expectations along with economic headwinds.

Bottom line

While political instability and other potential policy changes bring fresh longer term risks, the structural changes in Japan should continue.

Portfolio managers in our international and global strategies remain positive on the ongoing trend of Japanese firms improving their corporate governance, with companies focusing more on better capital allocation, improving profit margins and reducing cross-shareholder holdings in other companies. Furthermore, Japanese firms contain unique technologies in niche markets, building durable businesses with highly defensible moats. They are positioned to capitalize on global supply chain shifts amid heightened geopolitical tensions as companies and countries seek multiple sources for supplies. 

Read more on Japan:
Japan is at record levels: How high can the stock market go?
Japan: Will reforms unlock stock valuations?