In the second quarter of 2025, Japanese equities experienced a seismic shift in foreign investor demand, marking a pivotal moment in global capital reallocation. The Nikkei 225 surged 14.8%, outperforming U.S. markets and signaling a strategic pivot by international investors seeking value in an era of tightening monetary policy and geopolitical uncertainty. This shift reflects a broader reallocation away from the long-standing “carry trade” model—where investors borrowed in low-yielding currencies like the yen to fund higher-yielding assets—and toward a more nuanced, fundamentals-driven approach.
The End of the Carry Trade Era
For decades, Japan’s ultra-low interest rates made its bonds and equities unattractive to foreign investors, who instead sought higher returns elsewhere. However, the Bank of Japan’s (BoJ) gradual normalization of monetary policy—culminating in a hawkish stance by Q2 2025—has eroded the appeal of this carry trade. Rising bond yields and tighter liquidity have forced investors to reassess Japan’s role in their portfolios. The BoJ’s reduced intervention in bond markets, coupled with a stronger yen, has created a more level playing field for foreign capital to flow into equities without the drag of currency depreciation.
This shift is evident in the data: foreign investors added a net 6.81 trillion yen to Japanese equities in Q2 2025, the largest inflow in two years. While a single week in June saw a reversal (524.3 billion yen in net outflows due to Israel-Iran tensions), the quarterly trend remains robust. The BoJ’s normalization has also spurred demand for short-term Japanese debt, with foreign investors purchasing 1.5 trillion yen in bills—the highest in nine weeks—highlighting a preference for liquidity in uncertain times.
Strategic Reallocation: Why Japan?
Global investors are increasingly viewing Japanese equities as a haven amid trade tensions and U.S. market volatility. Japan’s corporate reforms, including record share buybacks and improved governance, have enhanced shareholder returns and attracted long-term institutional capital. Sectors like semiconductors (e.g., SoftBank’s $6.5 billion acquisition of Ampere Computing) and AI-enabled manufacturing have drawn attention for their strategic importance in global supply chains.
Moreover, Japan’s domestic demand remains resilient. Strong wage growth and a growing role in the AI supply chain have insulated the economy from some global headwinds. The government’s NISA (Nippon Individual Savings Account) system has also spurred retail participation, further stabilizing the market. Meanwhile, foreign investors are selectively targeting undervalued equities in sectors like real estate investment trusts (REITs), where stable occupancy rates and rental growth offset risks in private real estate.
Geopolitical Uncertainty and the Carry Trade’s Demise
The Israel-Iran conflict briefly rattled markets in June, prompting a week of net outflows from Japanese equities. However, this short-term caution did not derail the broader trend. Investors are now prioritizing diversification over yield-chasing, recognizing Japan’s structural advantages: a low-foreign-ownership equity market, strong corporate balance sheets, and a government committed to long-term reforms.
The end of the carry trade era has also forced investors to confront the risks of overexposure to U.S. assets. With the U.S. dollar weakening against the yen, Japanese equities offer a dual benefit: exposure to a resilient economy and a currency tailwind when converted back to home currencies. This dynamic is particularly appealing to European and Asian investors, who are reallocating capital to hedge against U.S. trade policy shifts and inflationary pressures.
Investment Implications and Strategic Recommendations
For investors, the sudden shift in Japanese equity demand underscores the importance of adapting to a post-carry-trade world. Here are key takeaways:
1. Sectoral Focus: Prioritize sectors with strong fundamentals and global relevance, such as semiconductors, AI, and financials. Japanese trading houses (e.g., Mitsubishi, Mitsui) and tech firms are prime candidates.
2. Currency Hedging: Given the yen’s volatility, consider hedging strategies to lock in gains as the currency fluctuates with BoJ policy.
3. Long-Term Value: Japanese equities remain undervalued relative to global peers, offering attractive entry points for patient capital. The NISA system and corporate reforms will likely sustain this momentum.
4. Diversification: Use Japan as a counterbalance to riskier emerging markets and overvalued U.S. equities. Its stable macroeconomic environment and corporate governance make it a defensive yet growth-oriented play.
Conclusion
The sudden surge in foreign demand for Japanese equities is not a fleeting trend but a strategic reallocation in response to global uncertainty and the end of an era. As investors move beyond the carry trade, Japan’s structural reforms, resilient economy, and undervalued markets position it as a cornerstone of diversified portfolios. For those willing to navigate short-term volatility, the opportunities in Japanese equities are both compelling and timely.
AloJapan.com