Japan’s equity market has long been viewed as a cyclical opportunity: buy during risk-on periods and sell before the inevitable downturn. After an exceptionally strong run for Japanese equities, it is understandable that investors might now be tempted to lock in profits.

Although a statement that often invites scepticism, those deeply engaged with Japan’s market dynamics are finding it increasingly difficult to argue that ‘this time, it is different’.

Dual tailwinds

Investors in Japanese equities have enjoyed remarkable returns over the past two years, with the TOPIX Index delivering a 55% gain, in local currency terms. While this performance slightly trailed the US market, fuelled by the recent AI-driven boom, it significantly outpaced other developed markets.

The market rally has been driven by two key factors: a weakening yen and the ongoing wave of corporate reform. Each has influenced the market in distinct ways and the question now is how these forces will continue to play out in the years ahead.

The weak yen

The driver behind the more traditional ‘buy risk-on’ mentality has been evident. Over the past two years, the yen has moved from 1:130 (dollar:yen) to near 1:160, a significant shift that has naturally correlated with the monetary tightening cycle in both Japan and, more notably, the US.

This depreciation in the yen has undoubtedly benefitted corporate Japan. Approximately one-third of TOPIX revenues originate from overseas. A closer look at the breakdown reveals that the TOPIX 100 derives 46% of its revenues from overseas, compared to 29% for the TOPIX Mid 400 and 15% for Topix Small indices.

The yen’s influence is even more pronounced when looking at market returns over the past two years. The TOPIX 100, which is the most sensitive to currency fluctuations, has returned 61%, while the Topix Mid 400 and Topix Small indices have both returned 42%.

Looking into 2025 and beyond, it is clear to us that the yen is too cheap at current levels

Looking into 2025 and beyond, it is clear to us that the yen is too cheap at current levels. Consider this: the average price of a beer in Japan is $3.20, whereas in Britain it is $6.20. In the long term, we remain confident the yen will find its natural equilibrium. In the short term, the outlook is less certain.

What is more certain, however, is that Japan’s small-cap universe has significantly lower sensitivity to currency fluctuations. It has had very little positive impact from the weaker yen, yet returns have remained strong, well ahead of the MSCI ACWI ex-USA Index. This is where corporate governance reforms come into play, acting as a key driver of performance.

The impact of governance reforms

Initiatives led by the Tokyo Stock Exchange (TSE) have driven a fundamental shift in corporate behaviour, capturing the attention of global investors over the past two years.

However, it is important to remember that these efforts did not begin with the TSE. The push to reform corporate Japan dates back to late 2012, driven by the policies of the late Prime Minister Shinzo Abe. Over the past decade, the groundwork has been laid, meaning that when the TSE introduced its policies, it did so in a corporate landscape that was already markedly different. The shareholder base had undergone a major overhaul – gone were many of the traditional, friendly cross-shareholders and overly accommodating domestic institutional investors. Instead, Japan now has a more financially driven and engaged shareholder base.

By moving away from entrenched affiliations and prioritising profitability, Japan is transitioning to a modern, globally competitive economic model

The unwinding of cross-holdings – once a defining feature of Japan’s relationship-based corporate culture – symbolises a broader transformation. By moving away from entrenched affiliations and prioritising profitability, Japan is transitioning to a modern, globally competitive economic model.

A prime example of this shift is the property and life insurance sector’s commitment to unwinding cross-held shares within five years. This move aims to fund share buybacks and mergers, ultimately fostering sustainable growth in earnings and dividends per share (EPS and DPS). Such structural changes are redefining capital allocation, enhancing transparency and placing greater emphasis on shareholder value.

These changes extend beyond financials, creating a ripple effect across industries, improving efficiency and reinforcing corporate accountability. At a market level, share buybacks nearly doubled year on year, an increase that was far from an anomaly. Even in 2023, buybacks were already at historically high levels.

Further reforms are on the horizon. Since their announcement in 2023, the TSE has been actively considering its next steps, engaging with us and other investors throughout this period. We anticipate that upcoming policies will place additional pressure on corporations, particularly regarding management buyouts (MBOs) and parent/child listings. These measures have the potential to accelerate the pace of reform even further, unlocking greater value for shareholders and reinforcing Japan’s transition towards a more dynamic and globally competitive market.

Opportunities ahead

As we look at 2025 and beyond, it is clear that these tailwinds may now begin to diverge. The yen may remain at current levels – or it may not – but a further 25% depreciation over the next two years, similar to what we have seen in the past two, appears unlikely. The era of easy returns, particularly from large-cap companies, is likely coming to an end.

However, in 2025, Japan’s corporate governance reforms remain a powerful catalyst, positioning the country as an attractive destination for investors seeking resilience, value and long-term growth. The foundations for reform have been firmly established and we are now entering a phase where the benefits are being realised. Even in an environment where no further reforms emerge, multi-year capital redistribution plans will continue to drive the market. That said, the likelihood of additional policy measures remains high, further compounding growth opportunities.

While the benefits of reform will be felt across the market-cap spectrum, the most compelling opportunities continue to lie in cash-rich smaller companies.

So, back to the key question: does this mark a profit-taking opportunity? No. Instead, it is an opportunity to rebalance and focus on the key drivers of growth going forward.