8. Emerging markets have the wind in their sails

The Japanese economy often dances to a slightly different rhythm to the rest of the world, and has been for the past few years. When markets were pricing in rate cuts from other major central banks, the Bank of Japan was hiking rates, albeit at a gentle pace. Looking further back, the Japanese economy has for several decades faced idiosyncratic challenges that other countries were happy to avoid.

Demographic headwinds are central to this story. Japan’s population peaked around 2010, and the resulting drag on domestic consumption forced the government to run large and persistent budget deficits to support the economy. The net result has been slow growth, weak pricing power and several lengthy periods of deflation, alongside a government debt‑to‑GDP ratio that would make many emerging market finance ministers blush (Figure 20).

However, there are tentative signs that things are changing. This is partly a relative phenomenon: Japan’s economy is no longer an outlier in terms of the challenges it faces. Demographic headwinds, persistently large budget deficits and elevated debt‑to‑GDP ratios are now commonplace across the developed world and also in some developing countries, so Japan’s situation no longer looks so unusual. But it is also because there are tentative signs of positive change for Japan. Whereas much of the rest of the world is only just starting to deal with problems associated with economic maturity and ageing populations, Japan seems to be emerging on the other side. The era of economic malaise that began with the bursting of the stock market and property bubbles in the late 1980s and early 1990s finally seems to be turning a corner.

From deflation to a new inflation equilibrium
Several positive developments are worth highlighting. In particular, the country appears to be in a new inflation equilibrium. In a very low or even negative inflation environment – which Japan experienced for 25 years from the mid‑to‑late 1990s – there are limited opportunities for wage increases, and this feeds through to weak consumption. That dynamic can then lead to a self‑reinforcing spiral in which a lack of demand is associated with reduced pricing power and the cycle begins again.

One of the few positive things emanating from Russia’s invasion of Ukraine is that the higher energy prices that followed appear to have kick‑started more durable positive inflation dynamics in Japan. These inflationary forces have subsequently been augmented by strong AI‑related demand and a weaker exchange rate.

The headline Japanese consumer price index (CPI) increased at an annual average rate of just 0.2% in the 30 years to end March 2022, during which time the country experienced deflation (negative inflation) in more than 40% of the months. Since then, Japanese consumer prices have increased by an average of 2.8%.

Core inflation – excluding fresh food and energy – has followed a similar pattern to the headline data. While too much inflation can be dangerous, a little bit of inflation is not necessarily a bad thing. It can facilitate adjustments to the real economy that would otherwise be more painful, and it also mitigates against the possibility that inflation is overestimated. It is for reasons such as these that central banks have positive inflation targets.

Wages finally responding: income growth and domestic demand
However, positive consumer price inflation that is not matched by wage inflation of at least the same order of magnitude is not good for an economy because it reduces individuals’ purchasing power. Another positive for Japan is that there are growing wage pressures, evidenced by the fact wages have grown faster than consumer prices in every month this year. Disaggregating this, there are some parts of the economy for which wage inflation is significantly above price inflation. So far this year, wage growth has averaged 3.5% compared to average headline inflation of just 1.6%. Furthermore, it is encouraging that wage growth appears to be most rapid for younger workers who tend to consume a higher proportion of their income than for older employees, who want to save for their retirements (Figure 22).

Our view for 2027

What does all this mean for Japanese markets and the economy in the year ahead? In terms of the headline macro picture, we do not expect significant change. Our baseline case sees low positive growth similar to that experienced in 2026, with inflation drifting back to target and another two rate hikes spread over the course of the year. However, there are clearly some important developments taking place within the Japanese economy that we believe will help support investor sentiment for the country’s stock market in 2027.

The more positive wage and consumption dynamics described above provide one important pillar of support. It is also notable that Japanese corporates have been transitioning to much stronger standards of corporate governance over the past decade. Together with higher interest rates, this is encouraging a much greater degree of capital discipline in Japan.

With foreigners notably absent from Japan in recent years, the combination of an improving macro backdrop, better corporate governance, a weaker yen and attractive valuations – many companies trade on valuations below their book value – provides significant opportunity for an increase in overseas demand for Japanese equities. If this were to happen at the same time as locals also increase their exposure to domestic stocks, for example because of higher average incomes and a shift in perceptions of risk, that could lead to a buoyant year for Japanese equities in 2027.

For you as an investor, the message from the Japan theme is to treat Japan as a strategic allocation again, increasing exposure through diversified equity strategies and focusing on quality companies that can turn better income dynamics, governance and global AI demand into durable returns. The points below translate this into concrete portfolio actions for the year ahead.