“Trade uncertainty is also likely to tilt market sentiment in favour of domestic-oriented companies, which have lagged over the past 12 to 18 months,” Dikov said in a note. “Japanese small and mid caps, which are more domestic-oriented, have also been overlooked in favour of large caps in recent years and can benefit from this shift in market dynamics.”

His views were recently echoed by Nicola Takada Wood, head of Japan at AVI Japan Opportunity Trust. She said that the tariffs on Japan would most likely be felt by Japan's export-oriented large-cap equities. “It is best to be less focused on those firms. Eighty per cent of the firms we invest in are domestically-orientated and less exposed to tariffs,” she said.

However, should tariffs remain at this level, without any concessions/exemptions from negotiations, Dikov thinks it is likely to weigh on Japan’s economic growth more than expected due to the potential global demand slowdown.

“On the corporate front, preliminary estimates on TOPIX’s annual profits suggest that autos, steel, and machinery industries, which make up most of its export trade value to the US, are expected to take the biggest hits from tariffs,” Dikov continued. “What is harder to predict is the possible ongoing/secondary impact on domestics and exporters’ profits from a potential US and global slowdown.”

Last Wednesday on social media, Trump announced a 90-day pause on the new reciprocal tariffs for countries that have so far refrained from retaliating, apart from China, causing the S&P 500 to climb 9.5 per cent. The US steel and aluminium tariffs that have been in force for some time will continue to apply as well as the baseline tariff of 10 per cent that took effect on 5 April. Nevertheless, Trump's post opens the door to potential tariff reduction deals for many trading partners.

“Looking ahead, should we see a softening in commodity prices along with a stronger yen, domestic cost-push inflation pressures may ease, and benefit industries tied to domestic consumption (e.g. domestic retail, railways, utilities) more than those reliant on exports and capex (e.g. autos, machinery, US-exposed retail),” he continued. “Reflation and the potential turn for real wage growth can provide some support for Japan’s domestic economy.“

Interest rates
“Bank of Japan will likely need time to closely assess how the tariffs will impact corporate earnings, wage negotiations and domestic inflation in the coming months before deciding on further rate normalisation,” Dikov said. “One of the key considerations for Bank of Japan is ensuring that any rate hike does not cause major disruptions to Japan’s recovery momentum or asset markets, as it did when the yen carry trade unwinding occurred in the wake of a surprise rate hike in July 2024. The yen’s fluctuations also play a significant role; a weaker yen boosts exports but raises the cost of imports, affecting inflation and domestic consumption.“

Dikov believes that the Bank of Japan must maintain its rate-hike stance to prevent further yen depreciation, whilst carefully managing the pace of hikes and market expectations through transparent communication to avoid dampening demand. The pace and timing will ultimately be dependent on economic data and global macro developments. Nomura Asset Management believes the next rate hikes will take place in July 2025 and January 2026.

Dikov thinks that retaliation is unlikely, given the Japan and US’ strategic alliance. “There could be a) more concessions/negotiations to increase imports from the US to reduce trade deficit, b) increase in investments in the US (i.e. Japanese automakers can consider building more factories in the US to reduce impact of tariffs), and c) reduction in non-tariff barriers (e.g. Japan-specific standards and testing requirements for goods, import licence requirements, cultural importance of business and personal relationships),” Dikov continued.

“On the domestic front, this year’s Shunto wage negotiations resulted in a 5.46 per cent nominal increase, the highest wage hike in over 30 years. Improving wage growth will result in higher disposable incomes and spur consumer spending, historically a weak link in Japan’s economy. This could become a more reliable growth engine for the economy and support domestic-oriented industries,” Dikov said.

“Corporate reforms provide an idiosyncratic, uncorrelated source of alpha for Japanese companies,” he added. “The reforms continue to accelerate with share buybacks surging by nearly 75 per cent in 2024 compared with 2023. Many Japanese companies, including small and mid-cap firms, still hold large cash reserves, which suggests that the strong trend for share buybacks and other corporate actions is likely to continue in 2025 and drive returns.”

Asset allocation
“A pocket of opportunity lies within the industrials and chemicals spaces, where many of the names have come under pressure over the past year as earnings were dragged down by cyclical weakness in their end markets,” Dikov said. “As a result, our analysis indicates they have become cheap on a through cycle basis, with strong upside potential should we see a demand recovery in the end markets.”

Dikov believes that maintaining a balance in both export and domestic companies, based on fundamentals and valuation, is key to capturing opportunities in both segments.

“Despite facing more severe tariffs than expected, initial estimates of their impact on Japan’s economy may not be as severe as other countries or as markets' reaction would suggest,” Dikov continued. “At the same time, corporate reform continues to provide an idiosyncratic, uncorrelated source of alpha for Japanese companies.”

“For investors who are wary of overpaying, Japan remains an attractive investment option based on valuations and fundamentals,” Dikov concluded.