A Japan-United States trade pact has not been finalized, and with the 90-day pause on the US tariffs ending July 9, we could see pressure on Japanese equities as that date nears. However, our base case sees the impact on most sectors in Japan contained at 8% or less. We expect that the US is unlikely to maintain higher tariffs, given the risk to economic growth. As a result, our view is that universal 10% reciprocal tariffs will remain, while steel and aluminum tariffs average 25% over the next five years. Meanwhile, we expect auto tariffs to ease over the next two years. Despite this, we think Japan’s auto industry will see material declines in valuation due to thin margins.
Our positive view of Japanese equities remains. We expect a continued trend of improving equity returns, driven by companies paying increased attention to capital allocation. The Morningstar Japan Target Market Exposure Index is up 2.4% this year as of June 17, in line with the S&P 500’s 2.5% return. Our coverage is slightly undervalued, trading at 0.89 times price/fair value ratio, and we see selective buying opportunities.
Japan Exports Mostly to Asia, Implies Greater Sensitivity to Global Growth Risks
In USD terms, exports to the US make up around 2% of Japan’s total exports, of which a large portion are autos and related parts. Autos make up more than 21% of total exports. More than 53% of exports are to Asia, which we believe consists largely of manufactured goods and machinery. We expect that most of these exports are sensitive to consumption, infrastructure, and capital investment plans. So while the impact from increased US tariffs will mainly be seen in the auto industry, a slowdown in global growth would indirectly harm Japan’s exports
The breakdown of exports by country has not changed significantly since 2008. Overall, in USD terms, Japan’s exports to China have been flat, which we think reflects a combination of global expansion by Japanese manufacturers being met with localized supply, a slowing in infrastructure spending that reduces the need for capital equipment, geopolitical sensitivities, and increased competition. Hence, the US remains a major and stable buyer of Japanese goods, and it’s not evident whether China can offset any shortfall in US purchases.
China’s consumption growth has been weak, pressured by the fall in real estate asset values. While we think the economy may have bottomed, the recovery will likely be slow. China’s government is likely to remain targeted in its stimulus policies. We expect China’s gross domestic product growth to hover around 3.5%-4.5%, based on World Bank and International Monetary Fund forecasts
Japan Is Likely Negotiating for Lower Reciprocal and Auto Tariffs
We expect that in its negotiation with the US, the Japanese government is focused on reducing the 25% import tariff on automotive products and the 24% reciprocal tariffs. The auto tariffs are a pre-April 2 policy and also affect production from Mexico and Canada, where Japan’s major car manufacturers have exposure. Morningstar Asia auto analyst Vincent Sun estimates that 10%-12% of their total sales volume could be subject to the tariffs. While US President Donald Trump’s administration raised import tariffs on iron and steel to 50% from 25% on June 4, the portion of iron, steel, and aluminum exports is relatively small, less than 5% of Japan’s total exports. As such, we expect the auto tariffs to be of more importance. Also, the acquisition of US Steel by Nippon Steel may be a mitigating factor for the latter’s sales.
As of June 24, Japan and the US continue to negotiate, with the 90-day pause ending July 9. If there is no agreement, we could see US tariffs on Japanese imports rise to an average of 32% in the worst case. This comprises the 24% reciprocal tariff, the 25% tariff on autos, and the 50% tariffs on iron and steel. However, we only place around a 25% chance that tariffs will stay at this high level over the next five years.
In all likelihood, we anticipate some agreement, as we do not expect the US economy to be able to withstand a high import duty on automotive products, and it will take time to onshore all supply. High reciprocal tariffs would also likely not be acceptable, as costs will be passed on to consumers. In turn, Japan could look to buy more energy from the US, and Mitsubishi has said it may consider investing in the Alaska gas pipeline project the Trump administration is keen to pursue.
Some other items may be on the table, such as asking Japan to spend more on defense or limiting technology sales to China, but those could be harder for Japan to agree to. Nonetheless, some limited aspects of both are possible.
Arriving at Our Scenarios
Our base case is premised on a trade negotiation leading to 10% reciprocal tariffs, down from 24% in our bear case. We also see auto tariffs of 25% diminishing to zero over the next few years, while iron and steel tariffs average 25%, down from the current 50%. Our bull case reflects an immediate removal of auto and iron and steel tariffs while reciprocal tariffs remain at 10%. We believe this could be in line with Trump’s campaign promise for 10% universal tariffs.
We based our estimates of the direct and indirect impacts of US tariffs on the fair value estimates of the Japanese companies we cover on a similar exercise our US equity research team undertook in May. We characterized the impact level on fair value estimates into three broad categories:
- Limited: a decline under 8%
- Negative: a decline of 8%-20%
- Very Negative: a decline over 20%
Because of limited US customer exposure, a diversified global customer base, and/or domestic-centric activities not subject to import duties, in our base case, 95% of our coverage is expected to face a limited valuation impact. For most of these companies, the impact will be from slowing economic growth rather than directly from tariffs.
The impact on Japan’s Big Three automakers is detailed in a recent report from senior equity analyst Vincent Sun. He believes Toyota, Honda, and Nissan could see 10%-12% of their car volume sales subject to tariffs. Because of their production plants in Mexico and Canada—where the Trump administration has applied additional levies—some auto sales could face up to 50% tariffs. For this reason, even if Japan is able to negotiate away all of the auto tariffs, there could still be a negative impact on the automakers, should the tariffs on Mexico and Canada remain.
Iron and steel companies will face a direct tariff impact, but since they only make up about 17% of the Japan TME Index, the significance is less material to the overall market. In contrast, the auto industry makes up 9% of the index, mainly due to Toyota’s large market capitalization.
In our bear case, we see either negative or very negative impact on 34% of our coverage. In terms of the Japan TME Index, almost half may see at least a negative valuation impact. Besides the auto industry, we expect Japan’s three largest banks to see their valuations negatively affected by declines in asset quality that lead to lower earnings. A slowing economy may also stall interest rate rises by the Bank of Japan, which would impede the improvement in margins. Overall returns on equity would be diminished.
Within the industrials sector, we think the factory automation and heavy equipment companies could face both direct and indirect tariff impacts. First, sales in the US are likely to be negatively affected by the tariffs hurting pricing and potentially leading to some absorption, resulting in higher costs. Secondly, slower global growth may dampen demand.
Elsewhere, select companies are likely to see specific sensitivities, given the importance of the US market. We expect Sony, Nintendo, Olympus, Kao, and Kirin to see a direct tariff impact on their US sales as costs associated with the tariffs will have to be passed on to US customers. For Recruit Holdings, the overall slowdown in activity will hurt revenue.
Japanese Equities Remain Selectively Attractive
While the bear case risks are not reflected in current valuations, we think most fair value estimates account for our base case of average five-year GDP growth of 0.8% for Japan and average US tariffs on Japanese imports of 14.3%. As such, we still see select buying opportunities in the Japanese market for investors looking out over a three-to-five-year period. Overall, we see our Japan coverage trading at 11% below our fair value estimate.
Japan market returns are mixed for the year through June 17. Outperformance by the industrials sector is largely offset by weakness in the consumer cyclical sector, which is weighed down by the share price falls in auto names. Non-auto consumer cyclicals are down, but only by 1.2%, while the auto and auto parts companies are down 7.6%, with index heavyweight Toyota falling more than 19% in the year to date.
While the basic materials sector is underperforming, the decline is led primarily by Shin-Etsu Chemical, which we believe is due to concerns over a weaker global semiconductor wafer demand outlook. Nippon Steel shares have fallen 13% year to date on tariff worries.
We are seeing robust positive returns among the gaming and entertainment industry components in the Japan TME Index, which is helping to lift communication services sector performance. The industrials sector has gained despite global growth worries, with defense and construction companies rising. Within the technology sector, the software and services industries are outperforming, offsetting slides in the hardware and components space. Notable strength is seen in the real estate sector as inflation drives rents upward and there is buying interest in properties.
Buying Opportunities
Based on our bottom-up analysis, the Japanese equity market is moderately undervalued, with our coverage trading at a 0.89 times price/fair value ratio. We believe the most attractively priced sectors are consumer cyclicals, technology, and industrials. However, we expect a mixed performance and have a preference for specific company equities. We make no attempt to represent of every sector. Hence, if our coverage in a particular sector is seeing limited upside to our fair value estimates, we may not have any ideas, such as for communication services. The following are short comments on the recommended stocks.
Consumer Cyclicals
Oriental Land
We like Oriental Land, as the theme park business model is largely sheltered from the impact of the tariff war, with over 75% of revenue coming from domestic visitors. We remain confident in Tokyo Disney Resort’s strong position as the most popular family-friendly theme park in Japan, making it more resilient than other forms of entertainment in case of a recession. Over the longer term, we anticipate rising wages and a higher proportion of household spending on entertainment to drive spending per guest.
LY Corporation
We are positive on LY, as the media conglomerate sells minimally to the US and is therefore largely unaffected by the tariff announcements We remain confident in LY’s advertisement, e-commerce, and financial technology ecosystem synergies. With services that serve as social infrastructure—that is, Line, the largest messenger app in Japan, and PayPay, the most popular QR code payment app—we think LY will be resilient even in case of an economic downturn and remain the preferred ad platform and business partner for retailers.
Consumer Defensives
Asahi Group Holdings
Asahi is little affected by the recent uncertainties, and its moat remains resilient in its key markets of Japan, Australia, and Eastern Europe. Management has demonstrated a track record of improving product mix and achieving cost savings, especially in Japan and Eastern Europe. Asahi has strong leadership in major Eastern European markets, which has the highest beer per capita consumption in the world. The Australian market was a drag on Asahi’s earnings last year, as demand was dampened by the twice-a-year beer excise tax hikes. But the Australian government has decided that it will cease beer tax hikes in the on-trade channels for two years. This should be positive for Asahi’s earnings.
Energy
Inpex
Inpex is Japan’s largest oil and gas exploration and production company, and trades at a discount to our fair value estimate. It has oil and gas projects across multiple continents, including the Ichthys LNG project in Australia and oilfields in Abu Dhabi. Our JPY 2,300 fair value estimate assumes a 3.0% 10-year compound annual decline in group EBITDA to JPY 1.22 trillion by calendar 2034. This assumes a decline in the Brent crude price to USD 60 per barrel from 2027, mostly countered by the addition of Abadi LNG production in Indonesia. We forecast group annual output growing to 285 million barrels of oil equivalent by 2034 from about 230 mmboe currently, including 50 mmboe from Abadi LNG. We assume a midcycle EBITDA margin of 72.5%, marginally below calendar 2024’s 72.9%. Inpex has 2 billion barrels of oil equivalent in proven and probable reserves, equivalent to more than 25 years of life at current group production rates.
Financial Services
Dai-Ichi Life Insurance Company
Although the current valuation, at 0.36 times embedded value, is only in the middle of Dai-Ichi Life’s trading range since its 2010 IPO, and its embedded value may only be diminished modestly by the Trump tariffs, we think the market is insufficiently recognizing the progress the company has made in the past few years in reducing its interest rate and other market risk. Given this, we see a fair multiple for Dai-Ichi Life at around 0.53 times embedded value, if not higher. Even if the denominator is adversely affected by economic slowdown and financial market weakness, the shares look undervalued.
Sumitomo Mitsui Trust Group
SMTG’s price/book ratio of 0.88 times is below the average of Japan’s three megabanks of 1.00 times, but we do not think its average return on equity over the next five years will be lower than the megabanks’, especially amid the tariff turmoil. SMTG has less credit risk than Japan’s other major banks and may be able to profit from opportunities to arbitrage interest rate differences between US and Japan, such as providing access to its balance sheet to Japanese regional banks seeking to access US dollar funding. Among Japanese banks, SMTG will have the largest benefit to its capital from the unwinding of cross-held shares, although lower stock prices may moderately reduce the size of onetime gains on sales compared with what could have been expected in March.
Healthcare
Daiichi Sankyo Company
Daiichi Sankyo is a global leader in antibody-drug conjugate drugs for cancer treatment. Its flagship drug, Enhertu, is a HER2-targeting ADC that has become a transformative treatment for some types of HER2-expressing cancers, and Daiichi has a pipeline of other ADC candidates for other cancers. We view shares as modestly cheap, based on our cautious assessment of currently available clinical data, but we also expect share price volatility since its prospects are so reliant on future readouts. In September 2024, a disappointing readout for Dato-DXd (TROP2-targeting ADC) in second-line lung cancer put a dent in Daiichi’s near-term growth prospects, but we think it should still enjoy strong growth, thanks to Enhertu.
Olympus
Olympus is a medical device maker with a leading position in the endoscope market and a diversified global revenue stream. We expect Olympus to enjoy long-term secular tailwinds as people pay more attention to the early detection of diseases and have a wider adoption of minimally invasive treatments. We believe the market remains pessimistic, given management changes in 2024 and a weak China demand outlook. However, we do not think its current leadership uncertainties should have a lasting impact on its fundamentals. The company appointed industry veteran Bob White as CEO, which should help contain further uncertainties. And we expect China’s revenue contribution to decrease to 10% or lower in the following three years. Looking beyond, we believe the earnings slowdown is temporary.
Industrials
Daikin Industries
Daikin has been a global residential and commercial air conditioner market leader in the past decade, thanks to its high brand reputation and strong technical expertise. In addition to sector leadership in Japan, we think Daikin is among the top five air conditioner manufacturers in North America and Europe, with broad sales networks. The firm also has solid footing in China’s premium air conditioner sector. We expect Daikin to post three-year compound annual growth rates of 6% for revenue and 11% for operating profit, due to product mix upgrades, deeper penetration in emerging markets, and more effective cost management.
Fanuc
Fanuc’s share performance has lagged as electric vehicle and semiconductor investment were sluggish, given the weak end-market demand. However, we see demand for factory automation improving as manufacturers around the world enhance their local production to meet local consumption in a bid to avoid the potential impact of tariffs. We think Fanuc will benefit from the increasing demand for factory buildup.
Hitachi Construction Machinery
We believe Hitachi shares are undervalued, as the market is overly concerned about its North American business, which is suffering from sluggish demand due to high interest rates and is restructuring. However, the near-term shortfall of new machine sales only reflects the inherent nature of the cyclical capital investment in construction and mining. In the long term, the company should achieve stable growth, mainly driven by the mining and value chain business, with its strong reputation and improved parts and service support through recent acquisitions.
Kubota
Kubota’s share price has declined nearly 20% since March 27, primarily due to cyclical headwinds in the capital goods sector and softening demand in key markets. However, we believe the market is overly focused on short-term pressures and underappreciates ubota’s structural strengths he company’s resilient market position is supported by its extensive dealer network, strong brand equity in compact equipment, and consistent investment in research and development, which helps maintain its competitive edge. Kubota trades at a P/E ratio of approximately 9.3 times, near the low end of its 52-week range and well below its historical average of 13.0–17.0 times. We believe the current dislocation presents an attractive entry point for long-term investors.
Yaskawa Electric
Yaskawa is the world’s largest supplier of servo motors, with a roughly 20% market share, and it’s one of the Big Four industrial robot manufacturers. We see Yaskawa’s 2024-29 earnings growing at a compound annual rate of 4.8%, primarily driven by secular growing demand for robotics products as the labor shortage continues. We think Yaskawa stock is undervalued because the market is overly concerned with the tariff impact and competition. Although North America accounted for 40% of segment sales in fiscal 2024, the North American factory accounts for only a single-digit percentage of overall motion control production capacity. However, the company has the ability and resources to ramp up the capacity if tariffs endure.
Technology
TDK
We believe TDK shares are undervalued because investors are overlooking the structural growth opportunities of its major products amid uncertainty. TDK is the leading global supplier of rechargeable batteries for smartphones. We believe the company will benefit from an improved product mix due to increased adoption of high-energy-density batteries with silicon anodes. This increase is driven by the release of thin smartphones. TDK is also the second-largest global supplier of multilayer ceramic capacitors for the automotive industry. This business will continue to benefit from the growing amount of electronics in cars and the increased adoption of electric vehicles. Lastly, TDK is the top supplier of hard disk drive magnetic heads. Increasing data center investment, driven by artificial intelligence demand, will provide a tailwind. Additionally, the company has focused on improving its business portfolio in its ongoing midterm plan, and progress on restructuring could be a catalyst for the company.
Tokyo Electron
Although there is increasing uncertainty about short-term demand for semiconductors, in the long term, demand for computing, centered on AI, is expected to continue to grow, and miniaturization to improve semiconductor performance will continue to be critical. With the number of semiconductor manufacturing processes expected to increase and become more complex, we expect Tokyo Electron to increase its market share, particularly in the etching field, and achieve growth that outpaces the market. Tokyo Electron has announced an ambitious plan to increase sales by more than 25% over the next two years
