Towards an Inflationary Economy - The "Great Change" Happening in Japan

Japan is undergoing an unprecedented structural transformation, which is expected to reshape the country's economic landscape and bring significant opportunities for investors.

According to the latest research report from Bank of America Securities, Japan is experiencing a series of structural changes, including a shift towards an inflationary economy, a reduced reliance on exchange rates, and accelerated corporate reforms, all of which create opportunities for investors to reassess the Japanese stock market.

Bank of America notes that the structural labor shortage triggered by the large-scale retirement of the baby boomer generation is driving Japan towards sustainable inflation, while the end of the excessively weak yen will improve trade conditions.

In addition, corporate reforms in Japan are showing authenticity and sustainability, with ROE expected to break through the historical ceiling of 9.5%. The opportunity for foreign capital to refocus on the Japanese stock market is forming. Reforms such as the dissolution of parent-subsidiary listing relationships, reduction of strategic holdings, and disposal of idle real estate are unlocking corporate value and enhancing capital efficiency.

Structural Inflation Transformation: Labor Shortage Drives New Economic Landscape

Japan's structural shift towards an inflationary economy is rooted in demographic changes.

During the period from 2012 to 2014, the large-scale retirement of the baby boomer generation became a key trigger for labor shortages. In recent years, three major factors have exacerbated the labor shortage.

First, between 2022 and 2024, many baby boomers who would have continued working will reach the age of 75, accelerating their exit from the labor market. Second, the female labor participation rate has significantly increased, reaching levels comparable to Germany and the UK, with the traditional M-shaped curve nearly disappearing; third, the work style reforms that began in 2017 have made it difficult for companies to adjust workloads through overtime.

Bank of America points out that this structural labor shortage is driving up wages and service prices. Currently, Japan's core CPI is expected to reach 1.9% in the fiscal year 2025 and 2.1% in the fiscal year 2026, forming a healthy and sustainable inflation pattern.

Reduced Reliance on Foreign Exchange: Yen Appreciation No Longer a Drag on the Stock Market

Japanese companies' sensitivity to exchange rate fluctuations has significantly decreased. According to Bank of America's estimates, for every 1 yen appreciation of the yen against the dollar, the TOPIX earnings per share only decline by about 0.35%, far below historical levels.

This is mainly due to two factors: first, Japanese companies are accelerating the relocation of production bases overseas; second, Japan is focusing on exporting high-quality products, which are less affected by exchange rate fluctuations.

The end of the excessively weak yen also helps improve ROE. Bank of America states that since 2022, the rapid depreciation of the yen has increased the amount of foreign exchange translation adjustments in financial statements, expanding shareholders' equity and causing ROE to lag behind the significant rebound in EPS. With exchange rates stabilizing, ROE is expected to break through the recent ceiling of 9.5%

Acceleration of Corporate Reform: Three Major "Deregulation" Trends Emerge

The transition to an inflationary economy has become a key catalyst for corporate reform. Firstly, companies can no longer justify hoarding cash that is depreciating. In fact, the cash holdings of Japanese companies show a negative correlation with inflation.

Structural labor shortages have also created a sustained demand for wage increases, prompting companies to optimize pricing strategies, improve the quality of products and services, concentrate capital on competitive businesses, and divest unprofitable operations. The main driver of price increases that began in 2022 was the surge in raw material prices; after a pause in 2023, the demand for funding wage increases has taken over this trend.

The regulatory measures from the Tokyo Stock Exchange (TSE) have also played an important role in promoting corporate reform. Companies responding to TSE's request to disclose reform measures have been more active in stock buybacks. During this earnings season, despite weak profit guidance, stock buybacks have increased to levels even higher than last year's record highs.

Bank of America states that corporate reform provides investors with three major thematic opportunities:

Deregulation of parent-subsidiary listings: After TSE's 2023 requirement for companies to focus more on capital costs and stock price management, the pace of deregulation has accelerated. Since 2024, the return rate of subsidiaries relative to their parent companies has continued to rise.

Reduction of strategic holdings: Companies that reduce their holdings significantly tend to engage in more stock buybacks, while companies with fewer strategic holdings usually have higher ROE, indicating that reduction helps improve capital efficiency.

Disposal of idle real estate: In an inflationary environment, the prospects for rising real estate rents and expanded business opportunities in the real estate sector provide disposal opportunities for companies holding real estate that is not highly synergistic with their main business.

Bank of America points out that, overall, Japan's structural transformation provides strong reasons for mid-term investment, although there are political risks in the short term, the long-term reform trend is worth investors' renewed attention.

Senate Election Risks: Short-term Volatility Factors

Despite the mid-term outlook being positive, Bank of America states that the Senate election on July 20 poses a major risk in the near term.

Unlike the House of Representatives election, the ruling coalition has less than half of the seats in the Senate that need to be re-elected, limiting the possibility of change. Historical data shows that the market tends to be cautious before elections and rebounds afterward.

All major opposition parties plan to include consumption tax reduction in their election manifestos, which may increase the risk of rising interest rates. However, Agriculture Minister Koizumi recently decided to directly release government rice stocks to retailers, and if successful in reducing the nearly 100% increase in rice prices, it may improve consumer sentiment and alleviate election risks.