In 2024, the old Yen carry trade blew up. Here’s what it means for 2025.

• Reasonable valuations, ongoing corporate reform, improved shareholder returns, and increased activism are all reasons to be positive about the 2025 outlook for Japan’s stocks.

• As inflation becomes more embedded in Japan, individuals are likely to switch some holdings out of cash and into stocks in hopes of returns.

• With risks of tariffs and a struggling Chinese economy looming overhead, investing in Japan’s more domestically focused, or small- and mid-cap companies may be a more lucrative play.

Of everything that happened in markets last year, the most surprising thing may have been the unwinding of the long-popular yen carry trade. The upheaval changed the game for folks who’d come to depend on the true-blue investing move and sent Japan’s main stock index into a tailspin – from which it has still not recovered. But this is a brand new year and with the dust finally settling over the land of the rising sun, I’ve decided to scan the horizon for new investing ideas.

What exactly happened in 2024?

Japan’s Topix was up 23% at its peak back in July, continuing a rally that saw it gain 25% the year before. But then things went haywire: concerns about a possible US recession and a couple of interest rate hikes from the Bank of Japan had sparked a massive unraveling of the yen carry trade. The popular investing ploy – which involves buying assets that promise higher returns using funds borrowed in the lower-yielding yen – suddenly no longer made sense, with Japan’s rates rising and US rates likely to fall. And, sure, the Topix eventually regained some of its losses, but it’s still trading 5% below those July highs. After all, that increased volatility – understandably – led some investors to sell their holdings in Japanese stocks.

What’s likely to drive Japan’s markets now?

Three things spring immediately to mind.

Valuations. Japan’s stock valuations appear pretty reasonable: the Topix index is trading at roughly a 14x price-to-earnings (P/E) ratio based on consensus earnings forecasts for the year ending in March 2026, with profits expected to grow by almost 10%. And this year, Japan’s stocks could have a particularly strong run – if, for example, healthy inflation levels prove to be back for good and if the positive knock-on effects from ongoing corporate reforms continue. Those things would likely offset any uncertainty surrounding US tariffs or China's persistent slowdown.

Inflation. After decades of entrenched deflation, prices have finally been rising – and that led the Bank of Japan to increase interest rates meaningfully for the first time in a while. Although the key rate is still only at 0.25%, that’s its highest level since 2008. Now, folks are watching for the next inflation foot to fall: the pace of wage hikes that result from the ”shunto” pay negotiations this spring between the country’s unions and its biggest employers.

Labor groups are expected to demand at least a 5% income increase, for what could be a third consecutive year of chunky salary bumps. And, since inflation has been driving profit growth, companies can afford to be more generous. And since higher prices undermine the idea of holding cash, that means individuals are likely to invest in stocks instead, to potentially increase their returns.

Corporate reforms. Further shareholder-friendly changes are expected in the first half of this year. The Tokyo Stock Exchange (TSE) has continued to pressure companies to improve “capital efficiency” – code for share buybacks, dividend payments, and the unwinding of strategic shareholdings.

And that’s already leading to an overall improvement in return on equity (ROE).Improved corporate governance has encouraged both companies and activist investors to be increasingly aggressive, which has boosted the pace of mergers and acquisitions, and management buyouts. The decline in stable shareholders resulting from the unwinding of strategic holdings has helped this along and is likely to continue in 2025.

A rise in ROEs could lead to an upward shift in the price-to-earnings ratio that investors will pay for stocks.

While the TSE recommended a minimum 8% ROE target, reports in December indicated that Toyota Motor (TM), Japan’s biggest company, is looking to nearly double its ROE to 20% – and that seems like solid proof that the recovery in Japanese stocks may still have upside.

What’s the opportunity here?

The key risks to investing in Japanese stocks are likely to be the impact of potential new tariffs from the US and the economic slowdown in China. So it makes sense to try to insulate yourself from those factors, by focusing on more domestic-focused companies.

In big-cap stocks, financials (think banks) could be a good bet, as they’re well positioned to see profits rise from higher interest rates and from exposure to the US economy – but with less worry about tariff risk. The heftiest – Mitsubishi UFG Financial Group (MUFG) – has an American Depositary Receipt (ADR) listing, which makes it easier for US folks to invest.

Aside from financials, many smaller and mid-size companies have more domestic demand exposure, and you can invest in those via the iShares MSCI Japan Small-Cap ETF (ticker: SCJ; expense ratio: 0.5%). Still, since some of the best opportunities in Japan seem to happen when shareholders engage with a company’s management to encourage improved governance and shareholder focus, it might be that a fund with a more active approach to investing could be worthwhile. Finding the right one is no easy task – but here are a few that seem to have the hang of it. For US investors, there’s the Hennessy Japan Small Cap Fund, and for British investors, there’s the Nippon Active Fund and the AVI Japan Opportunity Trust.

Lastly, though far from the drivers of activism, you might consider betting on a Japanese small-cap growth stock that appears set to benefit from the rise of humanoids: Harmonic Drive.

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