As the global economy begins to stabilize and experiences easing inflation, officials from the Bank of Japan (BoJ) have been vocal in their discussions regarding potential adjustments to their expansive monetary policies, such as negative interest rates and yield curve control (YCC). These dialogues have created a ripple effect in the market, notably shown by the recent uptick in the yields of 10-year Japanese government bonds (JGBs), a strengthening of the yen, and adjustments in the Japanese stock market, all reflecting growing concerns regarding the tightening of monetary policy.

The exit from "ultra-loose policies" can be perceived as a double-edged sword for Japanese equities, negatively influencing both the numerator and denominator in valuation metrics. The potential removal of the negative interest policy could lead to higher yields on JGBs, impacting the cost of equity, while shifts in the ultra-loose framework may lead to a stronger yen, complicating profit figures for companies relying heavily on exports. Since the beginning of 2023, the correlation between Japanese stocks and the yen has been notably negative. This inverts a trend where a depreciation in the yen typically supported the Japanese equities market by enhancing export revenues and magnifying currency conversion gains, given that as much as 41.6% of revenues for registered firms on the Tokyo Stock Exchange come from overseas. Japan's economy heavily relied on net exports, and a withdrawal from the ultra-loose policies could disrupt the current recovery path.

Despite several adjustments, the ultimate exit from the YCC policy may have a somewhat muted impact on bond yields. Essentially, the YCC is a strategy employed by the BoJ to maintain a cap on the 10-year JGB yields through unlimited fixed-rate bond purchases. Since August 2023, the central bank has not engaged in such operations, and in a September meeting, they lifted the rigid upper limit on YCC, rendering it nearly obsolete. Signals from the forward market indicate that the current yield on the 10-year JGB swap stands around 0.89%, with the spread against the 10-year JGB yield narrowing to merely 10 basis points, reflecting lukewarm expectations about an increase in yields. Moreover, recent adjustments in the previously warped yield curve suggest some restoration, while the long-term yields have remained relatively stable.

The scope for a significant appreciation of the yen seems limited. Furthermore, with the lagging effects of exchange rate changes, the upward trend of the yen may weaken its impact on corporate profitability. As hedging costs rise, the appeal of carry trades between the U.S. dollar and the yen wanes, alleviating fears of a significant reversal impacting the yen. Notably, movements in the yen's exchange rate generally precede shifts in Japan's export performance. Even when the yen was relatively strong earlier in 2023, the depreciation still afforded some continued support to Japanese company exports. Industries such as semiconductor production, which harbor significant portions of overseas earnings, tend to be cushioned against the adverse effects of yen appreciation due to their international pricing power and direct foreign engagements.

Additionally, Japan appears to be emerging from a "deflationary trap," now exhibiting signs of inherent economic momentum. The transition away from ultra-loose policies, coupled with ongoing consumer sentiment and fiscal stimulus, could pave the way for sustained economic recovery.

On a fundamental level, Japan's economy is gravitating towards normalization, and projections suggest that Japanese businesses might witness robust profit growth over the next two years. Recent results from the "shuntō" (spring wage negotiations) demonstrate that union members managed to secure an average salary increase of 5.3%, surpassing the 3.8% hike recorded in March 2023. This emergence of wage inflation may provide the necessary impetus for Japan to exit from its deflationary phase and achieve a broader economic normalization. During the previous currency depreciation phase, profit surges were observed in export-oriented sectors like information technology and non-essential consumer goods, while domestic-driven industries such as manufacturing and utilities are now expected to see profit recovery as the overall economy steadies.

From a financial perspective, international investments in the Japanese stock market remain relatively low. The ongoing reforms at the Tokyo Stock Exchange are beginning to reveal positive changes, which may further enhance the global attractiveness of Japanese enterprises. Since 2022, while the Japanese stock market has shown consistent growth, foreign investors have remained net sellers to the tune of ¥2.7 trillion, resulting in a lower comparative allocation in Japan than in the past. At present, the cost advantage for yen financing is still present, and reforms at the Tokyo Stock Exchange are likely to further amplify the allure of Japanese stocks.

In terms of market sentiment, the earlier upswing in Japanese stocks is supported by substantial profits, and numerous sectors now reflect relatively reasonable valuations, suggesting potential for upward movement. After experiencing substantial gains recently, indications of a decrease in equity risk premium imply a moderation of the investment appeal for Japanese equities. As of now, the equity risk premium for the Nikkei 225 stands at 3.7%, slightly below the standard deviation from the past three years. However, profitability, risk-free rates, and investor risk appetite have each contributed significantly to enhancing the Nikkei 225 index since 2012, with profit growth being the primary driver, accounting for 90% of the gains. Even amid recent fluctuations, the market still benefits from momentum driven by expectations of profit advancements over the next year, especially under the influence of AI development. The dynamic price-to-earnings ratio currently rests at a low of 22.5 times, significantly lower than in the 1990 "bubble period." Sector-wise, discretionary consumption and healthcare still have several points of valuation room for improvement with respective percentiles of 39.3% and 38.4%, indicating potential for growth.