Despite Japanese stock indices more than doubling since 2022, the underlying Return on Equity (ROE) for the market has remained flat around 9-10%. The next phase of the rally is contingent not on sentiment, but on tangible ROE improvements driven by aggressive restructuring, M&A, and shareholder returns.
Following the last three LDP supermajority victories (2005, 2012, 2014), Japanese markets saw an average 20% gain in the first three months. This initial surge is followed by a multiple expansion over the next nine months, driven by expectations of political stability and increased foreign investment.
Contrary to concerns that a large mandate would embolden populist spending, the scale of Prime Minister Takechi's victory provides political security. This reduces the perceived need for drastic measures like a promised consumption tax cut, reassuring investors in the FX and rates markets about fiscal discipline.
Following a historic election victory, the winning prime minister becomes personally associated with the pro-growth policies driving the market. Consequently, the biggest risk to the current rally is not economic but political: an unexpected resignation could abruptly end the cycle, as seen historically in 2006 with Prime Minister Koizumi.
When Japanese equities outperform U.S. markets on a dollar-adjusted basis, it triggers a "geographic diversification trade." This attracts a new wave of foreign investors, particularly from the U.S., whose capital inflows then push Japanese stock prices and multiples even higher, creating a positive feedback loop.