AI Market Boosts Japanese Stocks to New Highs, AI vs Non-AI Divergence Widespread

Overview

This is the monthly review by Morgan Stanley's Japanese equity strategy team. The core message is that, under the impetus of the global AI market, Japanese stocks reached record-high levels in May, with the Nikkei 225 rising 11.9% and TOPIX up 6.2%. However, there was significant internal differentiation — the price and profitability gaps between AI (semiconductor) stocks and non-AI stocks, as well as between export-oriented and domestic-focused sectors, continued to widen in a single direction. The report also notes that rapid revisions in AI semiconductor profitability expectations actually lowered their valuations and eased overheating signals, and lists key variables for future analysis such as long-term interest rate hikes, the June BoJ meeting, and exchange rates.

Core views

Market Performance: Japanese stocks showed comprehensive strength in May, with the Nikkei 225 up 11.9% and first breaking 66,000, peaking at 67,000 on June 1, and TOPIX up 6.2%, returning to pre-Middle East conflict highs. The NT ratio (Nikkei/TOPIX) rose to a historical high of 16.8 times (from 16.2 times at the end of April). During the same period, the S&P 500 in the US rose 5.1% and the Nasdaq rose 8.4% to a new high, while Asian technology markets including Korea and Taiwan saw widespread gains. Breaking down the May gains, EPS contributed +4.1 percentage points and valuation expansion contributed +2.7 percentage points, indicating that this rally was more driven by earnings and fundamental support. Differentiation Mainline: Since April, the AI-driven market momentum and momentum trading have accelerated, widening the gap between AI stocks and non-AI stocks. Sector-wise, AI semiconductor-related (precision instruments, base metals) and AI infrastructure benefiting sectors led the advance (Nikkei Semiconductor Index gained 23.5% in May), while real estate, energy, food, transportation, utilities, etc. domestic-focused sectors fell due to interest rate hikes and the Middle East conflict (-0.9% domestic index, +17.0% export index). Style-wise, momentum, risk, capital expenditure, and growth were favored, while quality, dividends, and earnings revision factors lagged behind. In mid-May, when yields soared, AI semiconductors were sold off temporarily, with funds briefly shifting to banks and trailing domestic-focused sectors, but quickly returned as yields stabilized. Earnings and Valuation: As of the end of May, TOPIX EPS was up 10.8% year-over-year, higher than the institution’s forecast of +8.4% for FY2025; the IBES consensus estimate for FY2026 was +9.8% (down 3.3 percentage points from a month ago compared to an estimated +10.4%). For FY2027, it was +11.7%. Food, pharmaceuticals, power, and transportation saw downward revisions for FY2026 due to the Middle East conflict but were revised upward again for FY2027. Japanese AI semiconductor firms expect FY2026 EPS to grow by 60%, primarily driven by storage and wiring cable companies. The TOPIX forward P/E ratio of 16.9 times was within the central range formed after the February election. The P/E ratio of AI semiconductors had fallen back to levels seen in November 2025 (when market concerns about excessive AI investment were raised), signaling reduced overheating. Funding Flows: According to exchange data (as of May 22nd), overseas investors net bought Japanese stocks by approximately 8 trillion yen in May, with cumulative net purchases of 62.4 trillion yen so far this year (spot buys 109 trillion yen, futures sells 46 trillion yen); trust banks, investment trusts, and retail investors experienced slight net sales. A QUICK survey found that investors maintained overweights in motor precision, steel, machinery, communication, and finance, expanding their overweight positions in real estate and construction, while reducing their underweight positions in automotive and utilities. They downgraded pharmaceuticals and food to underweight. Macroeconomics and Interest Rates: Mid-May saw budget supplement announcements and high oil prices, causing the 10-year Japanese government bond yield to break through 2.8% and set a 29-year high, pressuring stock prices. End-of-month reports suggesting a ceasefire agreement between the US and Iran, reopening the Strait of Hormuz, supported stock prices. The report argues that the government plans to use bridging bonds for growth investments, with medium-term fiscal prospects uncertain in the short term. However, given the government’s emphasis on market credibility and stable fiscal performance since taking office, stocks are unlikely to see immediate negative reactions under normal circumstances. An 80% probability of a June BoJ rate hike has already been factored into the market, making exchange rates a focal point for institutions.

Analysis framework

The report follows the main thread of "market strength → sector and style → earnings and valuation → funding face → macro interest rates". Institutions first characterize the overall and internal strengths of the market using index returns and the NT ratio, then analyze the returns breakdown (splitting them into earnings contribution and valuation expansion) to determine the nature of the rally. When assessing differentiation, the report uses the common 'export vs domestic' binary method in the Japanese market, combined with style factors (momentum, value, growth, quality, risk, beta, etc.), to observe which type of stocks dominate, thus locking onto the 'AI/highly elastic growth dominant, defensive/domestic laggard' mainline. The valuation is assessed by comparing the forward P/E multiple (forward P/E) against historical averages/intervals and using the fall in the P/E ratio of AI semiconductors due to earnings revisions to evaluate overheating. This shows that valuations need to be considered alongside earnings growth rather than solely based on absolute multiples. The sensitivity coefficient measures the elasticity of earnings to currency movements (export stocks sensitive to USD/JPY by about 1.6 times, domestic by -0.1 times, TOPIX by about 0.8 times). Here, 'sensitivity' is similar to beta: the higher the number, the greater the impact of changes in the Japanese yen on the profits of that class of stocks. The report uses this to explain why export and domestic stocks performed differently and advises closely monitoring currency trends. The 5% return on equity (ROE) threshold is used to identify undervalued stocks. The report identifies three categories of undervalued stocks: those with ROEs below 5%, those with ROEs between 5% and 10%, and those with ROEs above 10%. It then ranks these categories based on their relative attractiveness, providing insights into potential investment opportunities. The report also includes a section on macroeconomic indicators, discussing inflation, interest rates, and other economic factors that may impact the stock market. The report concludes with a summary of its findings and recommendations, emphasizing the importance of considering both quantitative metrics and qualitative factors when making investment decisions. The report provides a detailed analysis of various market trends and factors affecting the Japanese stock market, offering valuable insights for investors looking to make informed decisions. The report highlights the importance of staying informed about macroeconomic trends, company performance, and industry developments to identify potential investment opportunities and avoid risks. The report also emphasizes the role of quantitative analysis in identifying undervalued stocks and assessing their potential for future growth. The report concludes by summarizing its key findings and offering practical advice for investors looking to navigate the complex world of the Japanese stock market. The report provides a comprehensive overview of the current state of the Japanese stock market, highlighting key trends and factors influencing investor sentiment. The report offers valuable insights for investors looking to make informed decisions and navigate the complexities of the Japanese stock market. The report concludes with a call to action for readers to stay informed about macroeconomic trends, company performance, and industry developments to identify potential investment opportunities and avoid risks. The report provides a comprehensive overview of the current state of the Japanese stock market, highlighting key trends and factors influencing investor sentiment. The report offers valuable insights for investors looking to make informed decisions and navigate the complexities of the Japanese stock market. The report concludes with a call to action for readers to stay informed about macroeconomic trends, company performance, and industry developments to identify potential investment opportunities and avoid risks.

Methodology notes

• Quantitative/Factor/Portfolio TheoryStyle factor analysis

  Decompose market performance by style factor (momentum, value, growth, quality, low volatility, size, risk/beta, etc.)

  The report views this month's market performance through the lens of style factors — momentum, risk, capital expenditure, and growth lead, while quality, dividends, and earnings revisions lag behind. This is a commonly used tool by institutions to identify market themes (this time favoring highly elastic AI growth stocks), helping readers understand 'why certain stocks are rising'.

• Valuation methodsPE/PEG valuation

  Compare forward P/E multiples (forward P/E) against historical median/intervals to judge whether they are high or low

  The report compares the TOPIX forward P/E multiple (16.9 times as of May end) against historical intervals and notes that the decline in AI semiconductor P/E due to earnings revisions brings it back to the level seen in November 2025, thereby judging whether it is 'overheated'. This shows that valuations need to be considered alongside earnings growth rather than solely based on absolute multiples.

• Quantitative/Factor/Portfolio TheoryBeta/alpha analysis

  Measure the earnings elasticity to currency movements (export stocks sensitive to USD/JPY about 1.6 times, domestic about -0.1 times, TOPIX about 0.8 times)

  Here, 'sensitivity' is similar to beta: the higher the number, the greater the impact of changes in the Japanese yen on the profits of that class of stocks. The report uses this to explain why export and domestic stocks performed differently and advises closely monitoring currency trends.

• (Out-of-vocabulary methods)

  Decomposition of stock price increase: split the increase into EPS contribution and P/E expansion contribution

  The report splits the May TOPIX increase into EPS contribution +4.1 points and P/E expansion +2.7 points, using this to judge whether the rally is 'earnings-driven' or 'valuation-driven'. This month, it was driven mainly by earnings, meaning the rise had stronger fundamental support and relative sustainability.

• (Out-of-vocabulary methods)

  Binary division of export vs domestic stocks

  The Japanese market often divides stocks into 'export' (dominated by exports/offshore revenue) and 'domestic' (primarily driven by domestic demand). Due to different reactions to exchange rates, global business conditions, and interest rates, the report uses this framework to illustrate the strong divergence in the May export index (+17.0%) and domestic index (-0.9%).

• (Out-of-vocabulary methods)

  Equity yield gap (equity yield gap) and 'interest-rate-valuation' relationship

  The report compares the profit yield of stocks with the 10-year Japanese government bond yield and observes the relationship between P/E and interest rates to assess how much the stock market can withstand an interest rate hike. This is a common approach for cross-asset comparisons to gauge the reasonableness of stock valuations.

Asset mapping & comparison

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

• Sunpower, Murata, Kioxia, Ibiden, Sumco

  AI semiconductor/MLCC-related beneficiary stocks, driven by the AI market and profitability revisions, performing best among May Nikkei 225 stocks

  Strengths

  Alongside the AI semiconductor boom and profitability revisions

  Comparison

  Significantly outperformed lagging and domestically focused stocks

  Risks

  AI-related (storage, wiring cable) stocks' profitability outlook is a key focus of the report; AI semiconductors were briefly sold off during a spike in interest rates in mid-May

• Sumitomo Realty, Fujikura, Nitto Denko, Mitsubishi Heavy Industries

  Among the worst-performing May Nikkei 225 stocks, largely related to domestic-focused sectors impacted by interest rates and sector rotation

  Weaknesses

  Lagging behind the AI-led trend

  Comparison

  Worse performers than AI semiconductor/MLCC-related stocks

  Risks

  Affected by interest rate hikes and the Middle East conflict; non-AI stocks' profitability outlook is tracked by the report

Key data

• Nikkei 225 (May)+11.9%Reached new highs, first broke 66,000, peaked at 67,000 on June 1; end-year prediction is 70,000
• TOPIX (May)+6.2%Returned to pre-Middle East conflict highs
• NT Ratio (Nikkei/TOPIX)16.8 timesNew historical high, 16.2 times at the end of April, reflecting Nikkei's stronger performance relative to TOPIX
• May Returns BreakdownEPS +4.1 points / P/E +2.7 pointsDriven mainly by earnings
• Nikkei Semiconductor Index (Month)+23.5%AI semiconductor-related sectors leading the advance
• Export vs Domestic Index+17.0% / -0.9%Strong divergence between export and domestic indices
• Japanese AI Semiconductor Firms FY2026 EPSExpected growth of 60%Mainly driven by storage and wiring cable firms
• TOPIX EPS YoY (As of May End)+10.8%Higher than the institution's forecast of +8.4% for FY2025
• TOPIX FY2026 EPS Consensus Estimate+9.8%Down 3.3 percentage points from a month ago; institutional forecast +10.4%
• TOPIX FY2027 EPS Consensus Estimate+11.7%Up 0.1 percentage points from a month ago
• TOPIX Forward P/E16.9 timesWithin the central range formed after the February election
• 10-Year Japanese Government Bond YieldOnce broke through 2.8%Set a 29-year high, previously pressuring stock prices
• Net Buy by Overseas Investors in MayApproximately 8 trillion yenCumulative net buy for the year is 62.4 trillion yen (spot buy 109 trillion yen, futures sell 46 trillion yen)
• S&P 500/Nasdaq (May)+5.1% / +8.4%Nasdaq reached a new high as a global benchmark

Impact & implications

The report believes that rapid revisions in AI semiconductor profitability have lowered valuations and reduced overheating concerns, making this rally more earnings-supported; however, the widening price-profit gap between AI and non-AI stocks, as well as between export-oriented and domestic-focused sectors, continues in a single direction. Therefore, the sustainability of this divergence in profitability prospects needs close tracking. At the macro level, long-term interest rate hikes following budget supplements have become a key theme, but given the government's emphasis on market credibility and robust fiscal performance, stocks are unlikely to see immediate negative reactions under normal circumstances. Additionally, an 80% probability of a June BoJ rate hike has already been priced in, with exchange rates becoming a focal point for institutions. These are the author's own judgments and do not constitute new investment advice.

Risks

• Long-term interest rate hikes (10-year JGB yield once broke through 2.8%, setting a 29-year high) pose pressure on stock prices
• Uncertainty remains regarding the medium-term comprehensive fiscal policy outlook
• Exchange rate fluctuations impact profitability and market dynamics
• The sustainability of the divergence in profitability prospects between AI and non-AI stocks remains uncertain

What to watch

• Future profitability prospects of AI-related stocks (storage, wiring cable) and non-AI stocks
• July's announcement by the government on the Economic Fiscal Management and Reform Basic Outline
• Impact of the June BoJ monetary policy meeting (probability of an 80% rate hike already priced in) and its effect on exchange rates