Why this comeback story is gathering momentum.
For years, Japan was seen as a slow-growth market defined by deflation and cautious corporate behaviour. Now, that narrative is changing.
In this month's episode of Sound Bites, Min Zeng, Portfolio Manager of the Fidelity Japan Equities Fund explores how inflation, stronger corporate governance and AI-led investment are reshaping the world's fourth-largest economy and uncovering opportunities that many investors may have overlooked.
Topics covered:
- The structural shifts transforming Japan's investment landscape
- How banks and other sectors are profiting from inflation's impact on earnings growth
- Opportunities across financials, construction, AI and overlooked areas of the market
- The outlook for Japanese equities amid global uncertainty
This episode was recorded 22 October 2026.
Edited transcript
Lukasz de Pourbaix (LDP): Japan has been one of the best-performing markets in recent times. What has changed in terms of market structure, corporate governance, and the way companies are thinking about growth, and what does that mean for investors today?
Min Zeng (MZ): If I had to sum up Japan's transformation in two words, it would be inflation and corporate governance.
For decades, Japan operated in a deflationary environment. From a company's perspective, that meant selling prices often declined year after year, making earnings growth difficult to achieve. To protect profitability, businesses had to relentlessly cut costs, whether through reducing headcount, limiting wage growth, or scaling back investment and innovation. As a result, some of the strongest growth opportunities were concentrated among exporters that could tap into global demand rather than relying on the domestic economy.
On the policy side, the Japanese government spent more than a decade trying to reflate the economy through accommodative monetary policy and fiscal stimulus. At the same time, a series of corporate governance reforms encouraged companies to focus more on capital efficiency, shareholder returns, and long-term value creation.
The real turning point, however, has been the return of inflation. Initially, many investors viewed the post-COVID rise in prices as temporary, driven by supply chain disruptions, rising import costs, and a weaker yen. But several years on, inflation appears to be more durable. Importantly, it is increasingly being supported by domestic wage growth. With Japan's labour force shrinking, companies are having to raise wages to attract and retain employees, creating a more structural source of inflation.
This shift has fundamentally changed how businesses operate. For the first time in decades, many companies have been able to raise prices and pass higher costs on to customers. That has put a renewed focus on pricing power, revenue growth, and capital allocation. In a deflationary world, holding cash often made sense because its real value increased over time. In an inflationary world, companies are under greater pressure to deploy that capital more effectively, whether through investment, acquisitions, higher wages, dividends, or share buybacks.
The combination of sustained inflation and improving corporate governance has helped reshape the Japanese market, creating a broader set of growth opportunities beyond the traditional export-led sectors. In a deflationary environment, holding large cash balances made sense because their real value increased over time. Inflation changes that equation. Companies now have to think about how to deploy that capital more effectively, whether that's investing in organic growth, pursuing acquisitions, increasing wages, or returning more cash to shareholders through dividends and buybacks.
After more than a decade of efforts to improve corporate governance, inflation has become one of the strongest catalysts for changing corporate behaviour. It has forced management teams to think more strategically about growth, capital allocation and shareholder returns.
At the same time, growth in some of Japan's neighbouring economies has slowed, creating a more favourable competitive backdrop for domestic businesses. As a result, companies that previously struggled to generate meaningful growth are operating in a very different environment today, and the opportunity set within Japan has broadened considerably.
LDP: Japanese companies have historically been seen as holding excess cash and prioritising stability over shareholder returns. Has the return of inflation changed that behaviour, and can you share some examples of companies that have adapted particularly well to this new environment?
MZ: A good example is the banking sector. Historically, Japanese banks often held shares in their clients as part of long-standing business relationships. In recent years, many banks and insurers have recognised that these cross-shareholdings are no longer necessary and have actively reduced them.
In some cases, they've sold those holdings into the market. In others, they've approached the companies they own and encouraged them to buy back the shares themselves. Many of these companies have substantial cash reserves and have been willing to do so, helping to unwind relationships that were not essential to the underlying business.
The proceeds have often been returned to shareholders through higher dividends and share buybacks, reflecting a greater focus on capital efficiency and shareholder returns.
At the same time, banks are now operating in a much more supportive environment. Loan demand is improving, and higher interest rates are helping to expand net interest margins. As profitability increases, the conversation is shifting from simply returning excess capital to shareholders toward how that capital can be invested to support future growth.
In many ways, this reflects the broader evolution taking place across corporate Japan: first improving capital discipline and shareholder returns, and now increasingly focusing on growth and reinvestment opportunities.
LDP: Banks have been obvious winners from the normalisation of interest rates, while consumers have felt some of the pain from higher inflation. What other sectors or types of companies are benefiting from these changes, and where do you see the biggest opportunities in Japan today?
MZ: One area that's benefiting is companies tied to domestic investment and capital expenditure. As businesses become more confident in the economic outlook, they're increasingly asking: if growth is back, where should we invest?
We're seeing more capital being deployed across Japan, whether it's new and more efficient factories, data centres, warehouses, or even office redevelopment projects. That last one may surprise some people given the post-COVID experience elsewhere, but office vacancy rates in cities like Tokyo remain extremely low as employees have largely returned to the workplace.
You can see this shift in the macro data, with private capital expenditure continuing to accelerate. That, in turn, is driving demand across the construction sector.
What's particularly interesting is that this demand is colliding with a shortage of construction labour. As a result, companies looking to build new facilities are having to pay more, giving builders and construction-related businesses greater pricing power. In many cases, they're able to raise prices faster than the broader rate of inflation.
So, beyond the banks, construction and other beneficiaries of rising domestic investment are among the clearest winners from Japan's transition to a more inflationary and growth-oriented environment.
LDP: AI has been one of the biggest market themes of the past few years, with much of the attention focused on US tech giants or Korean semiconductor companies. How is Japan exposed to the AI theme, and where are you seeing the biggest beneficiaries within the Japanese market?
MZ: Japan's role in the AI story is a little different from what many investors might expect. While Japan was once a dominant force in semiconductors, particularly during the 1980s, much of that manufacturing leadership eventually shifted to the US, Taiwan and other parts of Asia.
That said, Japan never disappeared from the industry. In fact, many of the technologies and capabilities that underpin today's semiconductor ecosystem still have deep roots in Japan. Kioxia, formerly Toshiba Memory, for example, was the inventor of NAND flash memory, and Japan continues to have a deep pool of engineering talent and technical expertise.
Today, the government is pushing to rebuild domestic semiconductor manufacturing capacity as a strategic priority. But perhaps more importantly from an investment perspective, Japan remains a critical supplier to the global semiconductor and AI value chain.
While many well-known consumer electronics brands such as Sony, Panasonic and Canon are less prominent on the global stage than they once were, a number of Japanese companies have evolved into highly specialised leaders in semiconductor equipment, advanced materials, chemicals and precision components.
These businesses may sit behind the scenes, but in many cases they hold significant market share in highly specialised niches that are essential to chip production and data-centre infrastructure.
So rather than being a direct AI platform winner, Japan's strength lies in providing many of the enabling technologies that make the AI ecosystem possible. It's often the supplier of the tools, materials and components that sit deeper within the value chain, but remain absolutely critical to it.
LDP: Has AI been a significant driver of Japanese equity market returns in recent years as we've seen in other markets?
MZ: Certainly. AI's impact extends well beyond semiconductor manufacturers. As investment in AI accelerates, it drives demand across the entire supply chain, including semiconductor equipment, specialty chemicals, components and data centre infrastructure.
While Japan has relatively few pure-play AI or semiconductor companies, it has a broad range of businesses that play critical roles in these supply chains. As a result, many sectors across the Japanese market have benefited from the AI investment cycle.
That said, unlike in the US where AI has been concentrated in a handful of large technology stocks, Japan's market performance has been driven by a broader set of factors. AI-related capex has been an important tailwind, but so too have rising inflation, corporate governance reforms and a recovery in domestic investment.
LDP: How is the Fidelity Japan Equities Fund positioned today? Which areas of the market are you most constructive on, where are you finding the best opportunities, and which sectors are you approaching more cautiously?
MZ: I would broadly divide the Fund into two parts: domestic growth opportunities and global cyclical growth opportunities.
On the domestic side, we've seen consumers and businesses facing the K-shaped or quite a divergent economic growth model over the past few years. It’s not just restaurants or clothing, autos also sell into end consumers, and those businesses tend not to be able to, or have a hard time, passing on inflation without destroying demand.
Where we've focused on primarily over the past few years is B2B or business to government companies and industries that we tend to prefer have had a dynamic of tight supply relative to demand.
Construction is a good example with demand coming from capex and supply from labour. Financials, particularly banks, have also benefited from demand for capital versus supply of capital. That is the primary exposure within Japan and selected consumer-related businesses like watch companies and like some retail companies that are turning around or enjoying premiumisation.
I like this supply-demand dynamic as it typically translates into a rise in pricing power, which is usually something the market mis-forecasts. We all forecast growth, but it's very difficult to truly properly forecast price hikes or premiumisation and the impact of that on earnings. So those theses tend to have earnings uplift larger than expectation, and the stock valuations usually expand when we recognise the business quality is improving from pricing power rising.
On the global side of the Fund, our focus has largely been on cyclical technology, semiconductors, robotics and industrial businesses. These businesses, generally, are larger conglomerates in Japan that deal with energy infrastructure capex, multi-year government defence projects, and are cyclical but have long duration. The Fund's exposure to cyclicals, such as semiconductors and industrials, varies depending on where we think we are in the economic cycle and whether we see greater value in short-term acceleration or longer-term durability and visibility. Specifically, this is in memory, in fibre optic cables, in substrates, and in ceramic capacitors, which is where we are positioned today.
LDP: You mentioned watch companies as an area of opportunity, and I know that you have invested in Citizen. What's the investment case for this investment and why do you see it as an attractive opportunity today?
MZ: Citizen is a good example of an opportunity where the market's perception differs from the underlying fundamentals. We invested in the company around the middle of last year.
At first glance, watches don't appear to be a growth industry. Global watch volumes have been declining for years, and the rise of smartwatches from companies like Apple certainly hasn't helped traditional watchmakers. However, we think the more relevant story today isn't volume growth, but premiumisation.
A useful comparison is the music industry. While physical sales declined for years, the industry eventually stabilised and returned to growth as consumers shifted to digital and streaming services. We're seeing something similar in watches. Volumes have largely stabilised, and the focus has shifted to value rather than units sold.
At the same time, Swiss watches have become significantly more expensive, creating an opportunity for Japanese brands such as Citizen, Seiko and Casio. These companies offer high-quality products at attractive price points, and consumers are increasingly recognising that value proposition.
As a result, Japanese watchmakers are moving through a premiumisation cycle, raising average selling prices and improving product mix. That's driving not only revenue growth but also margin expansion.
What we found particularly attractive about Citizen was that the market still largely viewed it as an ex-growth business. Our view was different. We believe the premiumisation trend would lead to stronger earnings growth than investors expected, and the valuation didn't reflect that opportunity. That's where we saw the potential for both earnings upgrades and share price appreciation.
LDP: The Fund has delivered strong outperformance over the long term, but the last few months have been more challenging. What has driven that recent underperformance, and why do you remain confident in the portfolio's positioning going forward?
MZ: If we look at 2026, it's really been a tale of two halves. In the first half of the year, our excess returns were largely driven by several AI-related supply chain holdings. In the second half, the primary source of underperformance has come from the same sector.
One important development through the first half was that the Fund's exposure to the AI theme gradually increased as those stocks performed well. That wasn't necessarily because we were adding aggressively to positions, but because the holdings themselves were appreciating. As a result, the portfolio's tracking error, beta and overall sensitivity to the theme all increased.
We also saw correlations rise across parts of the portfolio. Companies in very different sectors began responding to the same underlying driver: AI-related investment. For example, some of our construction and engineering holdings benefited from data centre spending, while even Citizen has exposure through its machine tools business, where semiconductor demand is a key end market.
We did trim some positions around June and July, but not enough to materially reduce the portfolio's overall exposure to that theme. As a result, when the AI-related correction occurred, the impact on performance was greater than the benefit we had enjoyed earlier in the year, reflecting the higher betas and increased correlations within the portfolio.
That said, our underlying investment thesis has not changed. The recent weakness has been driven more by market positioning and sentiment than by a deterioration in the fundamentals of the businesses we own.
LDP: How have you responded to recent weakness in Fund performance from a portfolio management perspective? Have you been increasing positions where your conviction remains high, or has recent market volatility led you to reassess some of your holdings?
MZ: Generally, taking reactive action during periods of heightened volatility is rarely the best way to create long-term value. Our first step is always to revisit the fundamentals. We reassess our earnings forecasts, review our latest research and ask whether anything has materially changed in the underlying investment thesis.
In this case, our views on most of the businesses we own have remained intact and, in some cases, have actually strengthened. We then revisit valuation and consider whether the long-term opportunity has changed as a result of recent market movements.
That said, I haven't made large Fund changes in either direction. Markets can be signalling that something is changing, and until we have conviction on exactly what has changed, what's intact and what's genuinely broken, it's important not to overreact.
Instead, we've focused on becoming more selective. We've maintained our highest-conviction positions while refining the Fund's overall risk profile. The goal has been to preserve the key themes we continue to believe in, while being more deliberate about where we take cyclical risk and where we don't.
So, the response has been less about making dramatic moves and more about improving the quality and selectivity of the risks we're taking.
LDP: As you look ahead over the next 12 months, what are the key developments you'll be watching most closely, and what do you think will matter most for investors in Japan?
MZ: The biggest thing I'm watching is the macro backdrop. The portfolio is positioned around two key themes: Japan's domestic reflation story, which includes banks and other beneficiaries of inflation, and global growth opportunities, particularly in cyclical sectors linked to technology and AI. Both are ultimately sensitive to economic growth.
The biggest risk to our thesis would be a significant global slowdown that weakens demand enough to push Japan back towards a deflationary environment. That's the key tail risk given how the portfolio is positioned today.
Beyond that, politics remains an important watchpoint. We have elections and policy developments globally, but rather than trying to predict outcomes, our focus is on assessing the implications once policy direction becomes clearer.
In Japan, the backdrop remains supportive, with relatively accommodative monetary policy and expansionary fiscal policy helping sustain the reflationary environment.
Finally, investors are closely watching AI. From a fundamental perspective, our earnings forecasts for many AI-related businesses have remained intact, and in some cases improved. The bigger question is valuation: how much investors are willing to pay for that growth. The long-term opportunity remains compelling, but the debate today is around the pace and sustainability of future AI demand and investment.
