Trade risk alleviated, is the "second wave" market for Japanese stocks coming?

Bank of America’s strategy department has raised its year-end forecast for the Japanese stock market, believing that key positive catalysts—the US-Japan trade agreement and expectations for domestic fiscal expansion—have arrived.

According to the Wind Trading Desk, the institution recently raised its target for the Tokyo Stock Price Index (TOPIX) from 2,850 points to 3,050 points for the end of 2025, and the Nikkei 225 index target from 40,000 points to 43,000 points. As of the time of publication, the TOPIX was up 0.37% to 2,919 points, while the Nikkei 225 index slightly fell to 40,636 points.

Bank of America stated that this adjustment is based on the following points: First, the conclusion of the US-Japan trade agreement significantly reduces uncertainty, especially concerns about tariff impacts. Second, market expectations for government fiscal expansion have heated up following the Senate elections. Finally, strong capital inflows and large-scale stock buybacks have created a favorable supply-demand environment. Bank of America also slightly adjusted the expected price-to-earnings ratio (P/E) in its valuation model from previous levels to 14.5 times.

Bank of America believes that although the Japanese stock market may experience a slowdown in upward momentum in the short term, the bottoming and improvement of earnings expectations are likely to support a "second wave" of market activity within the year. Meanwhile, uncertainties in domestic politics, differences in the US-Japan $550 billion investment, and risks of stagflation in the US still need to be monitored.

Earnings Bottoming, Second Wave of Market Activity Expected

Bank of America stated that the current upward pattern of Japanese stocks is characterized by the expansion of the price-to-earnings ratio (P/E) outpacing the growth of earnings per share (EPS). This is not uncommon historically. Looking back at 2019 (expectations for a US trade agreement) and 2020 (fiscal and monetary stimulus during the pandemic), the market experienced a similar "valuation leading" phase.

The report pointed out that Japanese stocks may lose some momentum in the short term due to rapid price increases, until corporate EPS truly bottoms out and begins to improve. The 12-month forward EPS seems to have bottomed out, partly because the current fiscal year's EPS forecast has largely absorbed the negative impact of tariffs (revised down from an 8-9% growth forecast in March to 1.6%). As the market shifts its focus to stronger earnings growth in the next fiscal year, forward EPS is expected to gradually recover, thereby initiating the second wave of gains for Japanese stocks.

At the same time, from the perspective of supply and demand, two major forces are supporting the market. First, overseas investors have net bought Japanese stocks for 16 consecutive weeks, with this wave of purchases beginning after companies announced their annual performance in May. The report believes that the accelerating wave of reforms in the Japanese corporate sector, especially mergers and acquisitions (which accounted for over 10% of the global total in the first half of this year), is the core driving force attracting foreign investment. It is worth noting that, unlike the futures-driven rise before the significant drop last August, this round of purchases is mainly concentrated in the stock spot market, indicating stronger stability.

Second, the scale of corporate stock buybacks is enormous. The buyback plans announced for 2025 are growing at a record pace, which directly reduces the supply of stocks in the market and provides strong support for stock prices.

Three Major Potential Risks Cannot Be Ignored

Although there is still uncertainty in Japan's domestic political situation, the report believes that regardless of who ultimately governs, more aggressive fiscal expansion policies may be adopted to consolidate their ruling position. Whether the current Prime Minister Shigeru Ishiba remains in office or potential candidates like Sanae Takaichi come to power, expanding fiscal spending and promoting economic growth will be priorities. Although Takaichi's aggressive fiscal stance may raise concerns about fiscal discipline and rising interest rates, the declining influence of her faction also reduces the likelihood of unchecked fiscal expansion.

Despite the overall bullish tone, Bank of America also pointed out three potential risk factors that could disrupt the current optimistic outlook:

1. Domestic Political Direction: The high uncertainty of the political situation remains the primary risk.
2. "Misunderstanding" of the US-Japan Investment Agreement: Japan has agreed to invest $550 billion in the United States, but there are differences in the statements regarding profit distribution. The US side claims that "90% of investment profits will go to the US," while the Japanese side explains that this only applies to the equity investment portion, which accounts for 1-2% of the total investment, while the remaining loans and guarantees will normally incur interest and fees. If this is merely a difference in public statements, it is not a major issue, but if it reflects a fundamental misunderstanding, it could become a risk point in the future.
3. US Stagflation Risk: The lagging effects of tariffs may push up inflation in the US. The CPI data from June has already shown signs of price transmission, while employment indicators for small and medium-sized enterprises indicate downward economic pressure, constituting a potential stagflation risk.

Investment Strategy: Cyclical Stocks Still Have Upside Potential, Domestic Demand Sector Worth Watching

Bank of America believes that although cyclical stocks may temporarily pause due to an overall market slowdown, they still have upside potential in the long run. Their relative correction index is at a multi-year low, which is usually a signal for reversal. As the global manufacturing cycle (which has stagnated for nearly three years) may bottom out and rebound due to trade agreements and US tax cuts (including the direct expensing of capital investments), Japanese cyclical stocks related to US business (such as automobiles, industrial automation, engineering machinery, Air conditioning and other sectors still have potential.

At the same time, based on expectations of fiscal expansion in Japan, the domestic demand sector is also worth investors' attention. Industries including retail, services, construction, real estate, and finance are expected to gain market favor against the backdrop of leading economic indicators showing signs of bottoming out