The Bank of Japan has raised its main interest rate from 0.75% to 1%, the highest level since 1995, in a widely expected move that marks a significant step towards normalising monetary policy after three decades of deflationary pressures. The decision was approved by a vote of seven to one, with dissenter Toichiro Asada — a dovish new recruit to the board — opting to hold rates steady, warning that a hike could suppress aggregate demand by curbing business fixed investment and potentially triggering simultaneous declines in inflation, production and employment.
Japan’s headline inflation rate stood at 1.5% in May, still below the Bank’s 2% target, but the central bank’s policy statement flagged a risk that inflation could accelerate above that level as businesses pass on higher costs. “An increase in consumer prices across a wide range of items” was cited as a possibility, driven by surging global energy prices linked to the Iran war and the persistent weakness of the yen. A summary of opinions from the Bank’s two-day Monetary Policy Meeting on 15–16 June, published last Wednesday (24 June), did not attribute quotes but noted that most members warned of mounting price pressures as firms transmitted rising input costs to consumers. Tokyo’s core inflation rate, often seen as a leading indicator for nationwide prices, climbed to 1.9% in May from 1.6% in April, adding to the concern.
The weak yen lies at the heart of the inflationary dynamic. As a net importer of natural resources, Japan faces higher costs for energy, food and raw materials whenever the currency depreciates. The yen is currently trading at its weakest level against the US dollar since 1986, hovering around 161.70 as of 27 June, according to Macrotrends data. Traders are braced for the possibility of further government intervention — whereby the Bank of Japan and the Ministry of Finance tap their vast foreign-exchange reserves to sell US dollars and buy yen in an effort to strengthen the domestic currency and stabilise prices.
Normally, a rate hike by the BoJ would boost the yen’s appeal, but that has not happened this time. Alex Hart, investment specialist at fund manager Sumitomo Mitsui DS Asset Management, explains that the US economy and Federal Reserve policy are having a more powerful influence on the yen than Japan’s own rates. Markets had expected the US economy and job market to slow, which would have allowed the Fed to cut rates, but economic revisions have been stronger than anticipated, employment data has remained positive and inflation is still sticky. That has raised the possibility of a US rate hike instead, weighing on the yen’s relative attractiveness.
This dynamic also affects the so-called “carry trade”, in which investors borrow yen cheaply to invest in higher-yielding assets elsewhere. Hart notes that global economic conditions, rather than domestic interest rate differentials, are currently the main determinants of the yen’s direction. At the same time, higher inflation is encouraging Japanese consumers to buy more equities — selling yen and purchasing global assets — which creates additional downward pressure on the currency. Nonetheless, Hart does not expect further yen depreciation because government intervention is likely; even if it proves ineffective in the long run, it sends a signal to hedge funds thinking of shorting the yen.
The broader liquidity picture is also being watched closely by investors. Scott Gardner, investment strategist at J.P. Morgan Personal Investing, says the market is waiting to see how all these forces affect liquidity — the ease with which consumers and businesses can spend, borrow and invest. Despite the Bank of Japan slowly reducing its quantitative easing and bond-buying programme, Japanese commercial banks have been increasing lending and expanding their balance sheets, injecting a large volume of yen into the system. “The commercial banks have been producing loads of liquidity, even more yen that has got to find its way into the market,” Gardner says.
Where are the bright spots for investors in Japan?
Gardner’s team at J.P. Morgan has been overweight Japan since the start of the year in its Fully Managed range, which uses exchange-traded funds. He points to improving economic activity, the liquidity picture and a very pro-growth agenda from the Takaichi government as reasons for the positive stance. Hart identifies energy infrastructure-related stocks as strong performers, while banks, consumer names and defence also look promising.
The defence sector in particular has attracted attention as Japan ramps up spending to 2% of GDP, with the potential for further increases. Hart notes that some defence-related names have sold off amid global expectations that the war in the Middle East is ending, and that heavy aerospace, ships and tanks are being replaced by cheaper drones. But he argues that the long-term story remains intact. Mitsubishi Heavy Industries (TSE:7011) and Kawasaki Heavy Industries (TSE:7012), two of Japan’s largest listed defence contractors, are both investing in drone and unmanned aerial vehicle (UAV) technology. Mitsubishi Heavy Industries is developing interceptor drones to counter enemy drones, as well as collaborative combat aircraft and hybrid-powered UAVs with extended range in partnership with Yamaha Motor.
Technology has become the dominant theme in Japan’s investment case. The country is shifting from a “sleepy giant of mainly industrials and financials” to a technology leader, driven by semiconductors and artificial intelligence. Around 21% of the Nikkei 225’s top 10 holdings are in semiconductors, Gardner says, adding that the AI trade is in full swing across Asia — in Taiwan, Japan and Korea. While most of the big tech beneficiaries are US-based, the “picks and shovels” of the AI supply chain — the companies actually manufacturing the components and equipment — are predominantly in Asia. Japan’s semiconductor market is projected to reach more than $51 billion by 2025 and is expected to grow at a compound annual rate of 15.8% between 2026 and 2034. The Japanese government is actively prioritising and funding the semiconductor and AI sectors, spending proportionally more than Western countries, with initiatives such as Rapidus aiming to establish advanced manufacturing capabilities.
Kioxia Holdings (TSE:285A), the NAND flash memory manufacturer that spun out of Toshiba in 2018, has become the most valuable listed company on the Tokyo Stock Exchange by market capitalisation, displacing SoftBank and Toyota. Hart says there is currently a bottleneck in NAND flash memory — used in memory cards, USB sticks and SSD drives — and that Kioxia offers a pure play on that market. Toyota had held the top position for two decades before SoftBank overtook it at the beginning of June.
Hart also highlights the broader tech theme: earnings growth is coming largely from data centres, with high levels of capital expenditure in electronic components. Japan’s semiconductor manufacturing equipment suppliers — such as Tokyo Electron and Advantest — and wafer producers like Shin-Etsu and SUMCO hold significant global market shares.
How should you invest in Japan?
For passive investors, understanding the construction of the underlying index is crucial. The iShares Nikkei 225 UCITS ETF (LON:CNKY) has an approximately 40% weighting towards technology as of 26 June, because the Nikkei 225 is constructed by share price, meaning stocks with higher share prices (like Advantest and Tokyo Electron) dominate. In the MSCI Japan index, by contrast, each of those stocks makes up less than 3%, Gardner notes. Investing passively in Japan right now is therefore a big play on technology, and investors seeking diversification through Japanese equities may end up doubling down on tech exposure if they are not careful.
Active management can cast a wider net. Japan has around 4,000 listed companies, while even the broad TOPIX index only includes 1,500 names. “Most of the inefficiency in terms of market pricing — given poor sell-side analyst coverage and so on — is potentially more exploitable with smaller and less-known companies, which active management can find,” Hart says. Among actively managed funds, Baillie Gifford Japanese is a growth-focused option investing in large and medium-sized companies with high and sustainable growth potential, while Baillie Gifford Japan Trust focuses on medium to smaller companies. Man Japan CoreAlpha takes a value approach by investing in larger, established, unfashionable Japanese firms. AVI Japan Opportunity Trust (LSE:AJOT) invests in over-capitalised small-cap Japanese equities and uses constructive engagement with management.
For closed-ended investment trusts, J.P. Morgan Japanese Investment Trust (LSE:JFJ) and Schroder Japan Trust (LSE:SJG) are also available. Direct investment in Japanese shares is possible on some platforms but comes with restrictions — such as higher minimum investment amounts at Saxo or the need to give instructions over the phone at AJ Bell. For broad index exposure, any of the major fund providers offer Japanese equity trackers at relatively low cost, such as iShares Japan Equity Index or Vanguard Japan Stock Index. Japan makes up around 5–6% of the global stock market (the second-largest regional exposure after the US), so indirect access via global model portfolios or tracker funds will provide some exposure to the region.
