Morgan Stanley: De-risking in Japanese equities is still ongoing, but once risk exits, domestic policy, inflation, and AI/semiconductor themes create opportunities

Overview

This is an investor presentation on Japanese equity strategy. The report's core view is that while global macro visibility has weakened and Middle East risk has led investors to continue de-risking, domestic catalysts for Japanese equities are strengthening. Morgan Stanley believes Japan has entered a phase of more stable inflation, better wage-price pass-through, improved capex and productivity, and continued corporate governance reform. The report sets the TOPIX 2026 year-end target at 4,250 points and argues that the prior bull-case scenario has now become the new base case.

Core views

The report gives four reasons to stay bullish on Japanese equities. First, stable and sustainable inflation is changing corporate and household balance-sheet allocation, while NISA also supports residents increasing allocations to Japanese equities. Second, the LDP led by Takaichi secured more than a two-thirds majority in the House of Representatives, improving policy visibility, decision speed, and the certainty of executing growth strategy. Third, reforms at the Tokyo Stock Exchange and the 2026 revision of corporate governance guidelines are expected to improve cash usage efficiency, ROE, and valuations. Fourth, Japanese earnings and profit-margin expansion remain supported, with TOPIX forward EPS still rising. In terms of themes, the report favors AI/semiconductors, data center infrastructure, defense, energy security, infrastructure renewal, general trading companies, developers, and contractors as real-assets-related areas.

Analysis framework

The report uses a top-down equity strategy framework that combines macro inflation, policy, exchange rates, interest rates, corporate earnings, valuation, seasonal fund flows, technical indicators, and thematic investing. Its core methods include TOPIX earnings and P/E scenario analysis, global equity regional allocation comparisons, sector preference ranking, policy-theme mapping, screening of medium-term business plans in TDnet disclosures, analysis of corporate executive changes, and scenario assessment of Middle East energy risk and Southeast Asian supply-chain risk.

Methodology notes

• Stock strategyEarnings-valuation scenario framework

  Derive the TOPIX target level from EPS growth and forward P/E assumptions

  The report uses TOPIX yen EPS growth and a 17.0x forward P/E assumption to derive the 2026 year-end 4,250-point target, and emphasizes that the gap between bull and bear scenarios is large.

• Macro strategyInflation and reflation framework

  Stable inflation drives nominal growth, wage-price pass-through, and corporate pricing power

  The report believes Japan's output gap is narrowing and inflation is moving toward the 2% target, which will support wages, consumption, capex, productivity, and corporate profit margins.

• Policy themeTakaichi growth strategy mapping

  Group 17 strategic areas into long-term capital-attractive themes

  The report identifies economic security and supply-chain resilience, AI deployment and the computing revolution, and infrastructure renewal and national resilience as the three most durable capital-attraction lines under the Takaichi administration.

• Event analysisTDnet medium-term business plan screening

  Use disclosure text to identify companies likely to release medium-term business plans

  The report screens relevant announcements in TDnet disclosures, identifies at least 255 companies that may release medium-term business plans in the future, and focuses on companies where the CEO or CFO changed within 180 days before the announcement.

• Risk monitoringEnergy and supply-chain shock framework

  Assess the impact of Middle East energy supply and Southeast Asian operating constraints on Japanese corporate earnings

  The report argues that Asia is highly dependent on Middle East energy; if energy costs rise or Southeast Asian production is constrained, Japanese local operations and profits may be affected.

Asset mapping & comparison

Structured mapping from thesis to named assets (strengths, weaknesses, peers, risks).

• TOPIX

  Core index and target asset

  Strengths

  Rising earnings expectations, a 17.0x forward P/E assumption, and support from policy and governance reform underpin valuations; the year-end 2026 target is 4,250 points.

  Weaknesses

  The technical picture has not fully confirmed a recovery; if it falls below 3,500, it could point to the 200-day moving average around 3,300.

  Comparison

  The report ranks Japan behind the US but ahead of Europe and Emerging Markets in global equity allocation, supported by reflation and ROE improvement.

  Risks

  Lower global macro visibility, Middle East risk, Southeast Asian supply-chain shocks, tariffs, exchange rates, and Bank of Japan policy risk.

• Japanese equities

  Primary allocation direction

  Strengths

  Stable inflation, policy execution, corporate governance reform, household funds entering through NISA, and expanding corporate profit margins.

  Weaknesses

  Some domestic-demand growth stocks have been weak, and earnings revision momentum in externally oriented stocks has recently slowed.

  Comparison

  In regional preference, the report favors the US first, then Japan; Europe is constrained by earnings growth, while Emerging Markets require caution due to valuation and FX factors.

  Risks

  If reflation falls short, fiscal efficiency does not improve, or the BoJ is seen as behind the curve, valuation rerating may be limited.

• AI and semiconductors

  High earnings visibility theme

  Strengths

  Ongoing AI demand, rising cloud capex, tight memory supply, growth in inference demand, and expansion of the global semiconductor market.

  Weaknesses

  Valuations may already price in high growth; if cloud capex or AI demand slows, theme optionality may weaken.

  Comparison

  Compared with traditional software, the report stresses that AI deployment is not only a software theme but also covers semiconductors, robotics, and computing infrastructure.

  Risks

  Supply chains, capex cycles, excessive valuation, and a pullback in global tech risk appetite.

• Energy security and power-grid infrastructure

  Potential incremental theme after Middle East risk

  Strengths

  Reducing external energy dependence, restarting nuclear power, expanding renewable energy, and strengthening grid infrastructure may accelerate.

  Weaknesses

  Long project cycles mean policy, regulation, and capex rollout pace may limit short-term earnings realization.

  Comparison

  Against the backdrop of rising Middle East risk, the energy security theme has more direct policy and demand support than ordinary cyclical stocks.

  Risks

  Energy price volatility, weaker-than-expected policy execution, supply-chain bottlenecks, and rising project costs.

• Defense and shipbuilding

  Theme of economic security and external demand

  Strengths

  US pressure on allies to raise defense burdens, rearmament in Europe and Asia, and rising demand for Japanese defense exports may shift defense from a budget theme to an export-demand theme.

  Weaknesses

  Rule relaxation, export orders, and capacity expansion still take time, and changes in earnings structure remain uncertain.

  Comparison

  The report argues that if transfer rules for defense equipment are eased, related companies can benefit not only from domestic budgets but also from external demand.

  Risks

  Policy restrictions, fiscal constraints, delays in order confirmation, and valuations getting ahead of fundamentals.

• Japanese companies with Southeast Asian exposure

  Risk-exposed assets

  Strengths

  If supply chains remain stable, Southeast Asia remains an important sales and production region for Japanese companies.

  Weaknesses

  Fuel shortages in the Philippines, similar risks in Vietnam as a net importer, falling transportation activity, and rising energy costs may affect local operations and profits.

  Comparison

  The report notes that Thailand, India, South Korea, and Taiwan are especially vulnerable to higher energy prices, and a slowdown in Southeast Asia would pose earnings risk to companies with high regional exposure.

  Risks

  Energy supply shocks, production disruptions, rising costs, lower transportation activity, and weaker regional demand.

Key data

• TOPIX target level4,250 pointsMorgan Stanley's TOPIX target level for year-end 2026.
• TOPIX forward P/E assumption17.0xThe new forward P/E assumption is broadly in line with current consensus.
• Base-case EPS growthCY2026 +12%, next year +13%The yen EPS growth assumption used to support the TOPIX target level.
• LDP House of Representatives seats316 seatsThe Takaichi-led LDP secured a more than two-thirds majority, seen as positive for policy visibility and execution.
• Japan nominal GDP growthabout 2.5%The report believes Japan's nominal GDP growth will structurally exceed pre-pandemic levels; the 2013-2019 average was 1.6%.
• BoJ rate-hike path0.75% to 1.0% in June 2026, then 1.0% to 1.25% in April 2027Forecast from Morgan Stanley's Japan economics team for the Bank of Japan's policy path.
• USD/JPY path148 in 2Q 2026, 149 in 3Q, rebounding to 151 in 4QThe FX team expects a V-shaped USD/JPY path in 2026.
• Asia's dependence on Middle East energyAbout half of crude imports, 13-15% of refined products, and about 16% of natural gas come from the Middle EastEnergy supply uncertainty may raise costs and disrupt supply chains.
• Companies with potential medium-term business plan releasesAt least 255 companiesDerived from TDnet disclosure screening in the report.
• Japan FY2025 defense-related spendingJPY 8.7 trillion, about 1.3% of 2025 nominal GDPUsed in the report to discuss defense budgets, GDP share, and valuation upside for defense stocks.
• Global semiconductor market potentialMay reach USD 1 trillion by 2030Used to support the AI deployment and computing revolution theme.
• Bull-case assumption for cloud AI semiconductor TAMMay grow to USD 235 billion in 2025eBull-case assumption based on supply-chain data.

Impact & implications

The investment implication is that the main driver of Japanese equities may shift from being driven purely by global risk appetite and the exchange rate to being driven jointly by domestic policy, reflation, governance reform, and demand from strategic industries. If Middle East risk eases, the market may rotate from defensive de-risking back into thematic cyclical stocks; if risk escalates, attention may further increase on energy security, defense, infrastructure, power grids, and real assets. Investors need to track technical support around TOPIX 3,500, foreign buying seasonality in April-May, corporate medium-term plans, CEO/CFO changes, the BoJ policy path, USD/JPY, and US tariff risk.

Risks

• An escalation or rapid de-escalation of Middle East tensions could cause sharp asset rotation.
• Southeast Asian supply-chain shocks and operating constraints may weigh on overseas earnings of Japanese companies.
• Higher energy prices could compress margins in cost-sensitive industries, especially food, pharmaceuticals, transportation, and logistics.
• If TOPIX falls below 3,500, the technical picture could further point to the 200-day moving average around 3,300.
• The USD/JPY path, yen appreciation, and changes in carry trades may affect export-stock performance.
• Changes in US tariff policy could still affect earnings of Japanese exporters.
• The pace of BoJ rate hikes, real rates, and market judgment on whether the BoJ is behind the curve may affect valuations.
• If corporate governance reform, cash usage efficiency, and ROE improvement fall short of expectations, the scope for rerating will be limited.

What to watch

• Whether TOPIX can hold the key 3,500 support level and re-confirm an uptrend.
• Whether foreign investors turn net buyers in April-May in line with historical seasonality.
• The May earnings-season wave of medium-term business plan announcements, especially companies with CEO or CFO changes within 180 days before the announcement.
• The details of Takaichi administration's Basic Policy 2026, growth strategy, fiscal efficiency improvement, and economic security policies.
• The 2026 revision of Japan's corporate governance code and its impact on cash usage, ROE, and PBR/PER.
• The BoJ's rate-hike path, real rates, and financial conditions around June 2026 and April 2027.
• Whether USD/JPY follows the V-shaped path of 148, 149, and 151.
• Middle East energy risk, Asia's energy import costs, and operating constraints in places such as the Philippines and Vietnam.
• Whether AI/semiconductors, cloud capex, memory supply-demand, and inference demand continue to support earnings visibility.
• Defense equipment export rules, order backlog, and changes in revenue structure for Japanese heavy-industry companies.