Japan’s stock market has delivered one of the most powerful developed-market rallies of the past two years. The benchmark Nikkei 225 has surged 52% over the past 12 months, repeatedly hitting record highs since 2024. The broader Topix index has gained 12% this year alone and 41% over the past year.

After decades of stagnation narratives and deflationary psychology, Japan is no longer the forgotten market. According to Goldman Sachs, the rally is not yet exhausted.

Bruce Kirk, Goldman’s chief Japan equity strategist, stated that Japan remains “very much in the upward phase of the current market cycle,” arguing that the cycle began in autumn 2022 and has not yet peaked.

The recent landslide election victory of Prime Minister Sanae Takaichi has added a new layer of political confidence to the macro story. Investors increasingly view Japan as a stable, reform-oriented, pro-growth economy at a time when other global markets face policy uncertainty.

Yet the rally raises fundamental questions:

• Is this a structural re-rating of Japan Inc.?
• Or is it late-cycle momentum vulnerable to profit stagnation?
• Can political stability translate into sustained corporate earnings growth?

To assess whether Japan’s rally truly has further to run, we must examine political drivers, foreign capital flows, corporate profitability, valuation dynamics, and the broader macro environment.

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Political Stability as a Catalyst

Prime Minister Sanae Takaichi’s decisive election victory has been interpreted by markets as a reaffirmation of policy continuity.

Political stability matters in Japan more than it might in other developed markets because:

• Japan’s reform agenda requires sustained execution.
• Corporate governance reform is incremental.
• Monetary normalization requires careful coordination.

Investors remember the instability of past political transitions that often interrupted reform cycles.

Takaichi’s pro-growth positioning reinforces expectations of:

• Continued structural reform.
• Support for capital market modernization.
• Corporate governance improvements.
• Supply-side investment incentives.

Markets reward predictability.

In a world of geopolitical uncertainty and polarized politics elsewhere, Japan’s relative stability has become a competitive advantage.

The Market Cycle Since Autumn 2022

Goldman Sachs dates the beginning of the current cycle to autumn 2022.

That period marked:

• The end of extreme yen weakness panic.
• Initial corporate governance reform acceleration.
• Increased foreign institutional interest.
• Growing optimism around shareholder returns.

Unlike speculative bursts seen in some markets, Japan’s rally has been underpinned by:

• Balance sheet repair.
• Share buybacks.
• Dividend increases.
• Capital discipline.

However, the rally has not been linear.

The Topix experienced a sharp 24% peak-to-trough correction during the summer 2024 sell-off. That correction tested conviction but did not break the cycle.

Corrections in bull markets often reset positioning rather than end trends.

Foreign Capital Flows: Still Underweight

Recent data revealed net foreign buying of ¥1.8 trillion in the week before the election — the second-highest weekly total on record.

This suggests renewed enthusiasm.

Yet Goldman notes that global funds remain underweight Japan relative to historical allocations.

That matters.

When institutional investors are underweight a rising market:

• Pullbacks attract dip buyers.
• Allocation shifts can provide sustained inflows.
• Momentum becomes self-reinforcing.

Japan’s rally is partly driven by:

• Rebalancing from China exposure.
• Diversification away from US mega-cap concentration.
• Strategic asset allocation reconsiderations.

Foreign participation has increased — but the positioning suggests room for more.

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Corporate Governance Reform: The Structural Engine

One of the most transformative shifts in Japan over the past decade has been corporate governance reform.

The Tokyo Stock Exchange has pressured companies to:

• Improve price-to-book ratios.
• Deploy excess cash more efficiently.
• Enhance return on equity.
• Increase shareholder distributions.

Historically, Japanese firms hoarded cash and prioritized stability over profitability.

Reform efforts have:

• Increased buybacks.
• Boosted dividends.
• Encouraged activist engagement.

However, Bruce Kirk’s observation is critical:

Return on equity (ROE) has plateaued around 9–10%.

For a developed equity market, that is modest.

If earnings growth does not accelerate, valuation expansion alone cannot sustain the rally indefinitely.

The Profitability Question

Markets ultimately follow earnings.

Japan’s rally will depend on whether:

• ROE improves beyond the 10% ceiling.
• Margins expand sustainably.
• Capital allocation efficiency strengthens.

Flatlining profitability poses risk.

Yet there are positive drivers:

• Wage growth supporting domestic demand.
• Supply chain reshoring.
• Semiconductor investment expansion.
• Tourism rebound.
• Defense spending increases.

Japan is also benefiting from global industrial realignment as supply chains diversify away from China.

Corporate profitability may have lagged price gains — but structural drivers remain.

The Yen Factor

Currency plays a significant role in Japan’s equity performance.

A weaker yen historically:

• Boosts exporters.
• Enhances earnings translation.
• Supports Nikkei performance.

However, currency volatility can deter foreign investors.

If political stability supports more predictable policy coordination between fiscal authorities and the Bank of Japan, currency volatility may moderate.

Stable currency conditions combined with improving earnings would strengthen the rally’s foundation.

Valuation Dynamics

Despite strong performance, Japanese equities are not historically expensive relative to US counterparts.

Compared with:

• US tech-heavy indices.
• European defensive sectors.

Japan trades at moderate multiples.

Valuation re-rating has occurred — but not to speculative extremes.

That suggests the rally has not yet entered euphoric territory.

Risks to Monitor: What Could Derail Japan’s Rally?

Japan’s bull market narrative is compelling — political stability, foreign inflows, governance reform, and structural repricing. However, sustained equity cycles rarely advance without testing moments. The durability of this rally will depend on how the following risks evolve.

1. Profitability Stagnation: The Structural Ceiling Risk

The most critical risk is corporate profitability.

Despite strong index gains, return on equity (ROE) has plateaued around 9–10%. For comparison:

• US large-cap equities typically generate mid-teens ROE.
• European firms often operate above 12%.
• Emerging Asian exporters frequently exceed 15%.

Japan’s historical weakness has been capital efficiency, not revenue capacity.

If:

• Corporate margins fail to expand,
• Productivity gains remain modest,
• Cash deployment slows,

then valuation multiples may compress.

A market driven by re-rating (multiple expansion) must eventually transition to earnings-driven growth. If that transition stalls, momentum can unwind quickly.

This is particularly important because much of Japan’s rally has been justified on the thesis of governance reform translating into improved capital efficiency. If ROE does not break decisively above 10%, skepticism will grow.

2. Global Growth Slowdown: Export Sensitivity

Japan remains heavily exposed to global trade cycles.

Key sectors driving index performance include:

• Automobiles
• Industrial machinery
• Electronics
• Semiconductor equipment

A synchronized global slowdown — particularly in the US or China — would directly affect:

• Earnings visibility
• Export volumes
• Industrial capital expenditure

Unlike domestically driven markets, Japan’s equity cycle is tightly coupled to global industrial demand.

A US recession, renewed European contraction, or Chinese manufacturing weakness could interrupt Japan’s earnings trajectory.

3. Yen Volatility and Monetary Policy Normalization

Japan’s ultra-loose monetary policy has been a defining macro feature for over a decade.

As the Bank of Japan gradually exits yield curve control and adjusts policy, several risks emerge:

• Rapid yen appreciation could compress exporter margins.
• Higher domestic yields could reprice equity valuations.
• Bond market volatility could spill into equities.

A moderately stronger yen may signal economic normalization, which markets can absorb.

However, a sharp currency move — especially if driven by capital repatriation or global stress — could:

• Reverse foreign inflows,
• Trigger hedging adjustments,
• Compress earnings for exporters.

The path of monetary normalization must be carefully managed.

4. Foreign Flow Reversal: The Positioning Risk

Recent ¥1.8 trillion in net foreign buying highlights renewed global enthusiasm.

But foreign flows can reverse quickly.

Historically, Japanese equity rallies have been sensitive to:

• US interest rate changes,
• Global risk sentiment,
• Dollar strength,
• Emerging market stress.

If global funds are still underweight Japan, further allocation upside exists.

But once positioning normalizes or becomes overweight, the risk of abrupt reversals increases.

Markets often correct not because fundamentals deteriorate, but because positioning becomes crowded.

5. Political Reform Execution Risk

Prime Minister Takaichi’s victory has boosted confidence.

However, campaign rhetoric must translate into policy delivery.

Risks include:

• Delayed structural reforms,
• Fiscal expansion without productivity gains,
• Incomplete corporate governance enforcement.

Political stability alone does not guarantee economic acceleration.

Markets will monitor whether:

• Tax incentives stimulate investment,
• Labor reforms increase flexibility,
• Capital market reforms deepen efficiency.

Failure to implement reforms could cap long-term upside.

6. Geopolitical and Regional Security Risk

Japan operates in a geopolitically sensitive region.

Key tensions include:

• China-Taiwan relations,
• North Korea’s missile programs,
• US-China technology rivalry.

Heightened geopolitical friction could:

• Disrupt trade routes,
• Increase defense spending volatility,
• Impact investor risk appetite.

While such risks are low probability, they carry high impact.

Why Japan’s Rally Matters Globally

Japan’s resurgence is not simply a local story. It has profound implications for global capital allocation, developed market balance, and strategic asset positioning.

1. Diversification Away from US Concentration Risk

Global equity portfolios have become heavily concentrated in US mega-cap technology stocks.

If Japan’s rally proves structural rather than cyclical, it offers:

• Geographic diversification,
• Sectoral diversification,
• Valuation rebalancing opportunities.

Institutional allocators seeking to reduce US concentration may view Japan as a developed-market alternative with reform momentum.

That shifts global capital flows.

2. A Counterweight to China Risk

Over the past decade, China served as Asia’s primary growth engine in global portfolios.

Recent structural challenges in China — including property market stress and regulatory tightening — have led some global investors to reassess allocations.

Japan provides:

• Political predictability,
• Rule-of-law stability,
• Developed market governance,
• Exposure to Asian industrial supply chains.

If capital rotates structurally from China toward Japan, global asset weightings shift.

3. Repricing of Developed Market Cycles

Japan was long considered a “value trap.”

A sustained rally challenges that narrative.

If Japan transitions from deflationary stagnation to moderate growth and earnings expansion, it alters:

• Developed market return expectations,
• Cross-border capital cost assumptions,
• Currency strategy models.

This reclassification from “mature stagnation” to “structural reform growth” reshapes global macro thinking.

4. Global Corporate Governance Benchmarking

Japan’s governance reforms are closely watched by institutional investors.

If:

• ROE improves,
• Capital allocation becomes disciplined,
• Shareholder engagement strengthens,

then Japan becomes a case study in governance transformation.

Other markets may adopt similar reform frameworks.

This elevates Japan from peripheral allocation to governance model.

5. Currency and Bond Market Spillovers

Japan remains one of the largest holders of global sovereign debt.

If Japanese domestic yields rise:

• Capital repatriation could occur.
• Global bond yields may face upward pressure.
• Carry trade dynamics could shift.

Japan’s monetary normalization has global fixed-income implications.

Equity strength reinforces confidence, potentially accelerating policy adjustments.

6. Psychological Impact on Developed Market Sentiment

Markets are partly narrative-driven.

Japan’s rally signals:

• Developed markets are not limited to US leadership.
• Structural reform stories still exist in mature economies.
• Demographics do not entirely dictate stagnation.

The psychological shift matters.

If global investors begin to see Japan as a structural growth story rather than a tactical trade, capital flows become stickier.

Final Strategic Perspective

Japan’s rally matters not because of short-term index performance, but because it represents a potential structural inflection point.

The risks — profitability ceilings, global slowdown, policy missteps, foreign flow reversals — are real.

However, the global implications are equally significant:

• Asset allocation diversification,
• Reduced US concentration risk,
• Rebalanced Asian exposure,
• Governance-led re-rating,
• Bond market spillovers.

If Japan sustains earnings expansion and breaks above its historical ROE ceiling, the rally transitions from cyclical to structural.

If it fails, the correction could be sharp — but even then, the global conversation around Japan has permanently shifted.

For global investors, Japan is no longer an afterthought.

It is once again a strategic variable.

Long-Term Outlook

If political stability continues, corporate governance reform deepens, and profitability improves, Japan’s rally could transition from cyclical to structural.

However, sustained performance requires:

• Earnings growth.
• ROE expansion beyond 10%.
• Continued foreign participation.
• Policy discipline.

Goldman’s view that the cycle remains in its upward phase suggests confidence in these structural levers.

Yet the next stage of the rally must be earnings-driven rather than valuation-driven.

Conclusion

Japan’s equity rally reflects more than momentum. It represents a potential structural repricing of a market long undervalued and underowned.

Political stability under Prime Minister Sanae Takaichi has reinforced investor confidence. Foreign flows are returning, yet global funds remain underweight — leaving room for further allocation.

However, profitability remains the decisive variable. With return on equity flatlining near 9–10%, sustained gains require earnings acceleration.

If corporate reform translates into improved capital efficiency and margin expansion, Japan’s bull market could extend further.

If not, the rally risks plateauing.

For now, the structural drivers remain intact — and Goldman Sachs believes the upward phase is not yet over.

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photo source: Google

By: Elsie Njenga 

26th February,2026