Photo Joël Le Saux © Eurizon

The Japanese equity market is entering a new monetary policy environment.

By Joël Le Saux, portfolio manager at Eurizon

The Bank of Japan (BoJ) is expected to raise its policy rate by 25 basis points to 1.25% at its next meeting. As this move is already widely anticipated, the decision itself should have only a limited impact on the market. What will matter, however, is the central bank’s communication: market participants have recently revised their expectations for further rate increases and are now pricing in quarterly hikes through next summer, implying that the policy rate should reach 2% by then.

After three years of strong performance – with annual returns above 20% – the robust results recorded in 2026 are explained by several factors. Double-digit earnings per share growth expected in 2026 and 2027 appears to be the main driver behind this sustained rebound. Technology companies, which account for a significant share of the TOPIX index, are making a major contribution. Companies in the industrials and materials sectors are also benefiting from investments linked to artificial intelligence.

The normalisation of monetary policy is part of a broader shift in economic policy in Japan. Over the past two years, the BoJ has raised its policy rates, while the medium- and long-term yield curve has already normalised to a large extent. This development is particularly benefiting banks, which have substantial excess liquidity and short-duration bond portfolios. More broadly, Japanese companies are gaining increasing pricing power.

Corporate governance reforms, for their part, are structural in nature. Companies still have room to deliver higher returns to shareholders, as their payout ratios remain low by international standards. The unwinding of cross-shareholdings, the growing emphasis on return on equity and increasingly shareholder-friendly corporate governance are shaping the Japanese stock market just as much as the normalisation of monetary policy.

The yen’s recent appreciation has also surprised most market participants. However, at around 153 yen to the US dollar, the currency remains within the 145 to 160 yen range seen over the past two years. The yen’s weakness beyond 160, observed at the beginning of the summer, was probably unwarranted. At current levels, the impact on corporate earnings should remain limited. Most companies based their 2026 earnings forecasts on an exchange rate of 155 yen. Expected earnings growth for the TOPIX index in 2026 and 2027 should therefore remain broadly unchanged.

After its strong run, the Japanese equity market is no longer considered undervalued. Even so, current valuations still appear reasonable given expected earnings growth. Double-digit earnings per share (EPS) growth looks plausible to us. Domestic companies appear attractive from a valuation perspective, but their market capitalisation accounts for less than a quarter of the TOPIX and they are generally not mega-cap names.

The Japanese stock market is also more diversified than the US market. The largest company carries a weighting of 4%, while the second-largest represents only 2.5%. By comparison, the three largest US companies together account for more than 20% of the market. Compared with Europe, the sector also plays a far more prominent role in Japan. The Japanese market therefore offers attractive diversification opportunities for international investors.

The policy shift now under way is structural in nature. We see no reason for this tailwind to reverse suddenly. Japan is engaged in a virtuous cycle characterised by wage growth broadly keeping pace with underlying inflation, monetary policy normalisation and increasingly investor-friendly corporate behaviour. This is reflected in particular in higher dividends for shareholders, the reduction of cross-shareholdings and greater attention paid to return on equity. In addition, a more growth-oriented culture is gradually taking hold in the boardrooms of many companies. This is a new development and should support future earnings growth.

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