Japan – A Delicate Balance

Running it Hot: Benefits and Limits

Policymakers around the world are incentivized to run their economies hot. The war in Iran and acceleration of AI underscore a need for governments and businesses to pay up to withstand fragmentation, putting pressure on debt levels at a time when demographics have weakened and interest rates have risen from 100-year lows. Absent an AI productivity miracle, running the engine hotter creates a path of least resistance: wage growth and corporate earnings strengthen, labor markets tighten, and inflation lowers debt levels as nominal income grows faster than government borrowing.

Japan provides this case study. Shinzo Abe's "Three Arrows" in 2012 represented a shift toward doing whatever it takes to generate inflation — policymakers floored short rates, pegged the yield curve, and printed more money than anywhere else in the world. As a result, debt-to-GDP fell from ~260% five years ago to ~230% today, and in 2024 Japanese equities reached a new high for the first time since 1989. But running it hot has limits: currency weakness feeds into domestic inflation, which pushes bond yields higher, which increases the cost of servicing an already elevated debt stock. As interest expense consumes a growing share of budgets, it crowds out productive fiscal spending — defense, infrastructure, social investment — and central banks face mounting pressure to step in as buyers of last resort, blurring the boundary between fiscal and monetary policy in a way that is difficult to walk back. The war in Iran has potentially pushed Japan to these limits.

Election and Fiscal Agenda

In one of post-war Japan's largest electoral victories, the LDP won 316 out of 465 parliamentary seats, and together with coalition partner Ishin holds a 352-seat supermajority — a stunning turnaround from just seven months earlier when the LDP had lost control of both houses. The supermajority allows the party to override the opposition-controlled upper house on virtually all ordinary legislation, though constitutional changes such as a revision to Article 9 still require upper house approval and a national referendum.

PM Takaichi's fiscal agenda is ambitious. Cost-of-living was a leading issue even before the war, with consumers struggling through one of the most persistent bouts of inflation in a generation amid anemic real wage growth. The centerpiece is a temporary two-year suspension of the 8% consumption tax on food and non-alcoholic beverages — a policy that could create a JPY 5 trillion annual revenue shortfall, roughly 6% of total tax income. Additional measures include gasoline tax removal, income tax cuts for low-income earners, cash handouts, and industrial policy focused on tech, nuclear, and defense. Nominal wage growth is expected at 5–6%, with Shunto negotiations particularly important for assessing whether gains broaden to smaller firms. The administration faces a difficult balancing act: if the currency weakens too much, the erosion of purchasing power could outweigh savings from the tax suspension, undoing much of the intended relief. For more on the political setup and market implications, see our previous publication on Japan elections here.

Fragmentation, Defense, and the Iran Conflict

Japan is responding to a more fragmented world by fast-tracking defense spending from the longstanding 1% of GDP ceiling to 2% by FY2025 — two years ahead of schedule — with the 2026 budget a record ¥9 trillion (~$58B), up 10% annually. The government plans to revise its three core security documents by end-2026, departing from the traditional once-per-decade review cycle, with the objective of transitioning toward a more proactive Indo-Pacific security role while remaining anchored to the U.S.–Japan alliance.

But the same fragmentation that is driving the defense buildup is also exposing Japan's deepest structural vulnerability. With an energy self-sufficiency rate of around 13% — one of the lowest among major economies — more than 90% of crude oil imports transit the Strait of Hormuz, and domestic refinery infrastructure is largely configured for Middle Eastern crude. Japan is among the most exposed developed markets to the Iran conflict. The macro implication is a difficult growth-inflation tradeoff: higher energy prices slow output while pushing core inflation higher, complicating both the BOJ's normalization path and Takaichi's fiscal push. The government has deployed gasoline subsidies at roughly ¥500 billion per month, but this is best viewed as temporary mitigation rather than a durable solution given the strain on an already vulnerable fiscal position.

The impact on equity markets is highly path-dependent on oil. In our base case where oil averages $80 within a few months, we see TOPIX at 3,700–3,800 on a 16.5x P/E with an expected drawdown of 3,500. Outcomes deteriorate meaningfully from there — if oil plateaus around $100 or spikes above $140 for a sustained period, multiples compress and drawdown risk deepens, with TOPIX potentially falling as low as 3,100 in the most severe scenario.

BOJ: On Hold, but June in Focus

While the BoJ decision to hold rates in April was expected, the 6-3 vote split underscores a high probability of a rate hike in June. Much of the tightening is priced in with markets expecting two hikes through 2026, but we see a high bar for the BoJ to move beyond that. Japan continues to walk a stagflationary tightrope amid elevated energy prices, and the government's costly energy subsidy program, alongside other fiscal initiatives, is adding strain to public finances. Against this backdrop, the BoJ may need to maintain relatively accommodative policy to cushion against potential demand destruction. The yen strengthened briefly to 159 against the dollar but retraced following BoJ Governor Ueda's press conference, where he struck a balanced tone and emphasized growth uncertainties. For the Ministry of Finance, maintaining USDJPY at around the 160–162 "line in the sand" may be less costly than a broader loss of market confidence. That credibility could be increasingly tested if a prolonged conflict triggers a more severe and sustained energy shock, but so far, as evidenced by the intervention move last week, authorities remain committed to defending the watermark.

USDJPY has decoupled from interest rate differentials in a sustained and meaningful way — unlike the 2024 episode driven by carry trade positioning, the current depreciation reflects a more fundamental reassessment of Japan's fiscal trajectory. With 30-year yields above 3%, Japan is testing whether its fiscal strategy can be sustained before tighter financial conditions become binding. Our base case for year-end 2026 remains USDJPY 158 (156–160), and currency is not expected to be a drag on earnings by year-end.

The Bond Market is Where Tension is Most Visible

Japan's bond market increasingly reflects concerns about fiscal and monetary policy credibility. The 10-year JGB yield surged to 2.49%, the 30-year spiked to a record 3.88% before retreating, and the curve is steep at 0.75% overnight versus ~3.6% at 30 years — more pressured than other DM curves, consistent with ~230% debt-to-GDP. We expect the structural rise in yields to continue and would caution against taking long positions. Demand composition is shifting: Japan lifers own 15.8% of the JGB market but are buying less, particularly in super-long maturities, as JGB volatility creates unwanted balance-sheet risk. Within Japanese fixed income, we are focused on Japanese banks as primary beneficiaries of curve steepening through net interest margin expansion. We are neutral on Japan life insurers due to mixed impacts of stronger equities and weaker bonds, though we see buying opportunities on weakness in this core, high-quality sector — lifers offer 5.5%+ yields in A-rated names.

Mixed Picture for Equities

PM Takaichi's supermajority is pro-growth and fiscal-positive, pointing to beneficiaries in defense, tech, and nuclear energy. Medium-term, reflation supports earnings and corporate governance reform supports capital discipline — share buybacks remain elevated and operating margins have improved since 2023. Earnings growth for TOPIX has matched the S&P 500 since the financial crisis, though with more volatility. However, valuations at ~17x forward P/E look full for expected 9–10% earnings growth over the next 12–24 months. Our 2026 TOPIX outlook: base case 3,700–3,800, with NTM P/E of 16.5X. With limited upside to our year-end target, we remain tactically neutral at the index level. Within that stance, we see select opportunities in banking (rising domestic rates), industrials (supply chain resilience), and technology (AI). We are not recommending defense-related companies at the moment due to stretched valuations and minimal direct exposure to the theme.