Japan Outlook 2H26: Rally isn’t over – but the winners are shifting

• Near-term macro risks are rising. Higher energy costs are feeding through the economy, while the expiry of energy subsidies could further pressure household spending and corporate margins in 2H2026.

• The BOJ remains on a policy normalisation path. A second rate hike is possible in 2H2026 if inflation remains resilient or yen weakness persists, although the pace of tightening is likely to remain gradual and data-dependent.

•  Japan's corporate reform is entering a new phase. Improving ROE and valuations, coupled with a revised Governance Code focused on profitability and capital efficiency, should provide continued support for equities.

• Sector selection matters more than index exposure. We favour technology and financials, supported by AI investment and higher interest rates, while remaining cautious on autos, industrials and consumer sectors.

• Do not exit Japan, but rotate into small caps. Japanese small caps remain in the early stages of the corporate governance reform cycle and offer more attractive upside potential as reform adoption broadens across the market.

On 22 June 2026, the Nikkei 225 closed at a record 72,354 points, the first time in its 77-year history that the index has crossed the 72,000 mark. Year-to-date returns have reached approximately 34% in SGD terms as of 24 June 2026, making 2026 one of the strongest years for Japanese equities in the past decade.

Three key forces have driven Japan's rally year-to-date: easing geopolitical tensions following the US-Iran peace framework, renewed confidence in Japan's economic normalisation after the BOJ's June rate hike, and accelerating global AI investment that continues to boost demand across Japan's semiconductor ecosystem.

The key question for investors is whether these tailwinds are already fully reflected in market valuations, or whether the rally still has further room to run in 2H2026?

The macro backdrop: Resilient but energy cost pass through remains a key headwind

Japan's economy has navigated the first half of 2026 remarkably well despite its dependence on energy imports. More than 200 days of strategic oil reserves, diversified LNG sourcing, the gradual restart of nuclear power plants, and government fuel subsidies have helped cushion the economy from the global energy shock.

Economic data has largely validated this resilience. Headline and core inflation both remained below 2% in May, while three consecutive years of wage increases above 5% have finally pushed real wage growth back into positive territory (Figure 1). Rising incomes have helped support domestic consumption and reinforced confidence in Japan's reflation story.

Figure 1:  Real wage has turned positive

However, some factors that cushioned Japan’s energy shock in 1H2026 may become less supportive in the months ahead.  

The impact of higher energy costs has yet to fully work its way through the economy. Producer price inflation accelerated to 6.3% year-on-year in May as elevated crude oil and LNG prices filtered through industrial supply chains. At the same time, rising labour and raw material costs are putting pressure on corporate margins, prompting businesses to pass more of these costs on to consumers. According to Teikoku Databank, food and beverage manufacturers plan to raise prices on 2,269 products in July, more than double the 1,078 items announced for June. Early signs of this pass-through are already emerging, with Tokyo's core inflation, a leading indicator for nationwide price trends, accelerating to 1.6% year-on-year in June. This growing pipeline of price increases is likely to keep consumer inflation elevated and weigh on household spending in the months ahead.

On the demand side, demand momentum has shown early signs of softening. Core-core inflation, which strips out food and energy and best captures domestic demand conditions, dipped below 2% in April and edged further down to 1.8% year-on-year in May. Household spending fell 0.5% in April, indicating that rising prices are eroding consumers' real purchasing power. This headwind is likely to persist throughout the second half the year.

Figure 2: Japan’s core-core inflation shows softening momentum

A key risk for 2H2026 is Japan's looming "energy subsidy cliff". The government's JPY3.11 trillion support package is scheduled to expire in October. If energy prices continue to normalise, the impact should be manageable. However, if subsidies are withdrawn while global energy costs remain elevated, the resulting squeeze on household incomes and corporate margins could prove more severe than markets currently anticipate.

In such a scenario, the government would likely extend support measures. Yet doing so is becoming increasingly costly. While the BOJ still owns approximately 46% of outstanding Japanese government bonds and corporate tax receipts remain buoyed by strong earnings growth, each additional round of fiscal support carries a higher price. Additional fiscal stimulus would require greater bond issuance at higher costs, potentially complicating the BOJ's tightening cycle and raising concerns over fiscal sustainability.

This tension is already visible in the bond market. The 10-year JGB yield has climbed to 2.7%, and a move above 3% can no longer be ruled out if fiscal policy continues to offset monetary tightening. Such an outcome would weigh on equity valuations and could emerge as one of the most important headwinds for Japanese equities in the second half of 2026.

BOJ outlook: One hike delivered, another on watch

The Bank of Japan (BOJ) raised its policy rate to 1.0% on 16 June 2026, taking rates to their highest level since 1995 and signalling growing confidence in Japan's reflation trajectory.

The key question now is whether another rate hike will follow in 2H2026. We believe the answer is a conditional “yes”. While core-core inflation has moderated in recent months, it remains close to the BOJ's 2% target and continues to suggest that underlying price pressures are becoming more embedded in the domestic economy. Reinforcing this view, Tokyo's core-core inflation, a leading indicator for national inflation, accelerated from 1.6% year-on-year in May to 1.9% in June. Together with sustained wage growth, this provides the foundation for further policy normalisation.

That said, the timing of the next move remains highly uncertain. The BOJ is likely remain cautious as it assesses the impact of higher energy costs and moderating growth.  A second rate hike is most likely if inflation stays persistently above target or if the yen weakens further beyond JPY160 per US dollar, exacerbating imported inflation pressures.

While the pace of tightening may be gradual, the direction of travel remains clear: Japan's monetary policy is moving towards further normalisation rather than a return to ultra-loose settings.

Table 1: Potential triggers for a second BOJ rate hike in 2026

Scenario	Growth	Inflation	BoJ Response
Gradual normalisation	Moderate slowdown	Near 2% target	Continue gradual, data-dependent normalisation
Second hike later in 2026	Limited damage	Persistently above 2% target	One additional hike becomes more likely
Faster tightening	-	Inflation materially overshoots target	BOJ may accelerate tightening
Pause	Sharp deterioration	-	Pause further tightening to assess growth risks

The reform engine: Running rapidly with significant room to go

Perhaps the most compelling element of the Japan equity story — and the one most immune to near-term macro noise — is corporate governance reform. The structural transformation continues to reshape how Japanese companies allocate capital and generate shareholder value.

The progress made over the past few years has been remarkable. Since the Tokyo Stock Exchange (TSE) launched its capital-efficiency reform initiative in 2022, the percentage of Nikkei 225 constituents trading above a price-to-book (P/B) ratio of 1.0 has risen significantly (Figure 3). Meanwhile, return on equity (ROE) among Nikkei 225 constituents has improved to approximately 12% as of the end of May 2026. Governance standards have also strengthened, with more than 99% of Prime Market companies now meeting board independence requirements.

Figure 3: 77% of the Nikkei 225’s company trade above 1X P/B ratio

Importantly, corporate governance reform is entering a new phase, with the focus shifting from compliance to measurable improvements in profitability, capital efficiency and shareholder returns. The TSE has also begun tightening liquidity and market-capitalisation requirements, reducing the TOPIX weightings of persistently weak companies and plans to remove chronic laggards from the index by July 2028. For investors, this creates a multi-year catalyst for continued improvements in ROE.

Perhaps the most underappreciated development is that these reform incentives are increasingly extending to the small and mid-cap universe. In 2026, the TSE tightened listing requirements for the Growth Market, requiring companies to achieve a market capitalisation of at least JPY10 billion within five years of listing, effective 1 March 2030. The exchange has also introduced new mechanisms to facilitate engagement between institutional investors and smaller listed companies, improving transparency and investor access across a segment that has historically received limited attention.

This matters because the reform opportunity among smaller companies remains largely untapped. As of May 2026, only 54% of Standard Market companies, where the majority of Japan's small- and mid-cap universe resides, had disclosed plans to improve capital efficiency, compared with 94% of Prime Market companies. In other words, while governance reform among large caps is already well advanced, the journey for many small-cap companies is only just beginning. With year-to-date gains in Japanese small caps driven primarily by earnings growth alone, the scope for multiple expansion remains substantial.

Earnings outlook: Strong growth, but widening dispersion

Japan's FY2026 fourth-quarter earnings season was exceptionally strong, with aggregate earnings rising approximately 45% year-on-year, driven by AI-related semiconductor demand, yen weakness and corporate governance reforms. However, the earnings outlook for the second half of 2026 is likely to become increasingly uneven.

Information technology remains our most preferred sector. The global AI investment cycle continues to gather momentum, and Japan remains well-positioned to benefit from it. Companies such as Advantest should continue to enjoy robust demand for semiconductor testing equipment as memory supply remains tight and production capacity expands. Meanwhile, Kioxia stands to benefit from rising demand for NAND flash storage driven by cloud infrastructure, data centres and the growing adoption of AI-enabled devices.

Beyond the global semiconductor upcycle, Japan is accelerating its AI ambitions. The government recently unveiled a JPY10.5 trillion public-private investment plan to develop physical AI across 17 strategic industries through 2040. Alongside Rapidus, Japan has also launched a new AI consortium led by SoftBank, NEC, Honda and Sony to develop advanced foundation models for robotics and industrial automation. Together, these initiatives strengthen Japan's position in next-generation AI and semiconductors, providing a long-term tailwind for the technology sector.

We also remain constructive on financials, which are among the clearest beneficiaries of the BOJ's normalisation cycle. Japan's three megabanks each reported more than 30% profit growth in the latest quarter and expect a combined JPY535 billion increase in net interest income this fiscal year. With rates likely to trend higher and credit costs remaining low, financials offer one of the most durable earnings growth profiles in the market.

In contrast, we have become more cautious on consumer-related sectors. Household spending is showing early signs of softening. Should current energy subsidies expire as scheduled in September, household disposable income could face an additional squeeze. While this may not derail consumption altogether, it is likely to weigh on discretionary spending and limit earnings growth across consumer-facing sectors in the second half of 2026.

Additionally, Japan's automotive sector continues to face mounting challenges from US tariffs and intensifying competition from Chinese manufacturers. Even before the energy shock, earnings momentum had already weakened. Toyota reported a 48% decline in fourth-quarter FY2026 profits, while Honda posted a FY2026 operating loss following EV-related write-downs and restructuring charges. Higher energy and raw material costs in the second half of the year are likely to add further pressure to margins. As a result, we remain underweight autos and have revised down our earnings expectations for the broader industrial sector accordingly.

Figure 4: Earnings forecasts for FY2027

Downgrade Japan to 3.0 stars “Attractive”: Rotation, not retreat

We continue to believe that Japan's long-term investment case remains intact. Corporate governance reforms still have significant runway, AI-related earnings growth remains structural, and a gradual path of monetary normalisation should support a stronger yen over time, improving the quality of foreign capital inflows even if it moderates earnings growth among exporters.

That said, the risk-reward balance has become less compelling after the market's strong first-half rally. Rising energy cost pass-through, softening domestic demand, rising bond yields and richer valuations have collectively reduced the Nikkei 225's upside to 11.0% by FY2029, based on our target price of JPY 76,820. As a result, we are downgrading Japanese equities from 3.5 stars to 3.0 stars while maintaining an "Attractive" rating.

This is not a call to exit Japan. Rather, we believe investors should adopt a more selective approach and focus on areas where earnings momentum and structural tailwinds remain strongest. We continue to favour information technology and financials, which stand to benefit from AI-related investment and the ongoing monetary normalisation cycle, respectively.

We also recommend gradually trimming some exposure from large-cap companies into Japanese small caps, which have yet to participate meaningfully in the market's re-rating. The MSCI Japan Small Cap Index offers an estimated upside of approximately 23.4% to our FY2029 target of USD 248, presenting a more compelling risk-reward proposition than the broader market.

Table 2: Recommended Products

Japan	·       Eastspring Investments - Japan Dynamic AS SGD ·       Amova Japan Equity SGD (formerly Nikko AM) ·       Xtrackers Nikkei 225 UCITS ETF 1D (LSE: XDJP)
Japan Small Cap	·       Janus Henderson Horizon Japanese Smaller Companies A2 USD ·       BNP Paribas Japan Small Cap Classic Cap SGD ·       iShares MSCI Japan Small Cap ETF (NYSE: SCJ)

Table 3: Earnings projections for the Nikkei 225 Index

	FY2026	FY2027E	FY2028E	FY2029E
PE Ratio (X)	29.7	25.4	20.8	18.0
Earnings Growth	28.7%	16.8%	22.4%	15.4%
Earnings Per Share	2,329	2,720	3,329	3,841
Dividend Yield	1.2%	1.3%	1.3%	1.4%
Target Price (JPY) (Based on fair PE ratio of 20X)				76,820
Upside Potential				11.0%
*Each fiscal year ends 31 March. FY26 refers to the 12-month period ended 31 March 2026. Source: Bloomberg Finance L.P., iFAST Compilations. Data as of 24 June 2026.

Figure 5: Price vs EPS for the Nikkei 225 Index

Table 4: Earnings projections for the MSCI Japan Small Cap Index

	FY2026	FY2027E	FY2028E	FY2029E
PE Ratio (X)	20.4	17.9	15.2	13.8
Earnings Growth	3.2%	14.1%	17.7%	10.1%
Earnings Per Share	9.9	11.3	13.3	14.6
Dividend Yield	2.3%	2.5%	2.5%	2.5%
Target Price (Based on fair PE ratio of 17X)				248
Upside Potential				23.4%
Each fiscal year ends 31 March. FY26 refers to the 12-month period ended 31 March 2026. Source: Bloomberg Finance L.P., iFAST Compilations. Data as of 24 June 2026.

Figure 6: Price vs EPS for the MSCI Japan Small Cap Index

Declaration:

This research report was prepared with the assistance of artificial intelligence (AI) tools. iFAST Financial Pte Ltd does not rely exclusively on AI for content generation; the content of this report – including all investment theses, ratings, price targets and conclusions – has been independently reviewed and verified by the research analyst(s) to ensure accuracy and professional integrity.

For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) and the analyst who produced this report hold a NIL position in the abovementioned securities.