Goldman Sachs' Major Outlook for Japan in 2025: Inflation Passes a Key Threshold, the Next Bull Market in Japanese Stocks Relies on Earnings!

After experiencing a long period of deflation and economic stagnation, the Japanese economy has finally ushered in a turning point.

In mid-month, Goldman Sachs pointed out in its 2025 Japan Economic Outlook report that Japan has crossed a critical inflation threshold— a benign "wage-price spiral" has emerged, and this shift has significant implications for both Japan and global markets.

Goldman Sachs expects that next year, Japan's consumption, exports, and capital expenditures are all likely to maintain an expansionary trend, which will accelerate economic recovery, with real GDP growth reaching 1.2%.

The positive inflation and economic outlook will support the normalization of monetary policy. Goldman Sachs predicts that the Bank of Japan will raise interest rates by 25 basis points in January and July next year, with the policy rate reaching 0.75% by the end of 2025.

Considering the ongoing trend of corporate profit growth, Goldman Sachs is optimistic about Japanese stocks, forecasting that the TOPIX index is expected to rise to 3100 points in the next year, 14.2% higher than Monday's closing price.

Inflation Crosses a Critical Threshold

After three decades of low inflation pressure, the rebound in inflation and wage growth prompted the Bank of Japan to exit its negative interest rate policy in March and raise interest rates again in July.

In the summer of 2024, Japan's base wage growth rate reached 3%, a level considered consistent with sustainable inflation by the Bank of Japan. Goldman Sachs also believes this indicates that the risk of low inflation in Japan has passed, and interest rate hikes will continue.

The report predicts that in the spring 2025 wage negotiations, the base wage growth rate will remain at 3-3.5%, slightly lower than 3.6% in 2024, but still at a high level, indicating that a benign "wage-price spiral" that helps anchor inflation expectations has emerged.

Given the increased bargaining power of workers due to intensified labor shortages and an expanding job mobility market; large companies announcing significant wage increases to cope with future labor shortages, which also affects small and medium-sized enterprises that employ about 70% of Japan's workers; and the continued growth in corporate earnings, we expect base wage growth to remain at a high level.

As wages rise, the prices of corporate services are also accelerating, and the cost-push pressure from direct and indirect wage growth may further intensify, especially in labor-intensive service industries. Goldman Sachs estimates that if labor costs and corporate service prices both increase by 3%, and these increases are fully passed on, it will lead to an overall CPI increase of 1.1-1.5%, which is a key factor for sustainable inflation in the future.

Moreover, further downward pressure on the yen may bring additional inflationary pressure to Japan. Goldman Sachs has raised its forecast for the USD/JPY exchange rate over the next 12 months from 149 to 159 yen. In fact, the weakening of the yen this year has already significantly pushed up prices since the summer.

With the forecast of the USD/JPY exchange rate remaining at a high level of 150, Goldman Sachs expects Japan's core CPI (excluding fresh food and energy) to grow by 2.1% year-on-year in 2025 and by 2.0% in 2026, slightly exceeding the central bank's target

Economic Recovery Accelerates, Consumption, Exports, and Capital Expenditures Expected to Maintain Expansion

Goldman Sachs expects that the Japanese economy will accelerate its recovery in 2025, with real and nominal GDP growth rates reaching 1.2% (slightly above the potential growth of 0.7%) and 3.4% (more than double the average level of 1.6% from 2013 to 2019).

The main drivers of this growth come from the expansion of consumption and equipment investment. The growth of real wages is expected to drive real consumption, while labor shortages, green transformation, digital transformation, and the continued expansion of corporate revenues are expected to drive increases in equipment investment.

As real wages rise, private consumption gradually increases

Goldman Sachs points out that although private consumption has declined in recent quarters, consumption shows stronger resilience to inflation as "Shunto" drives the growth of real wages. The growth of real wages is expected to turn positive in the summer of 2024, and this trend is anticipated to continue, supporting consumption growth.

Capital expenditures continue to grow moderately

Goldman Sachs believes that due to corporate profits being at historical highs and business sentiment remaining positive, corporate capital expenditure plans are active, and capital expenditures are growing moderately.

Capital expenditures are driven not only by medium- to long-term demand unrelated to the business cycle (such as decarbonization and digital transformation) but also influenced by labor shortages. Due to a shortage of skilled workers in the construction industry, the construction cycle for factories and other facilities is prolonged, preventing companies from fully implementing their capital expenditure plans. However, as long as corporate investment willingness does not collapse under supply constraints, capital expenditures are expected to continue to grow moderately in the coming years.

Commodity exports are expected to maintain moderate expansion

Goldman Sachs believes that despite some risk factors, Japan's commodity exports will still grow moderately. This growth is mainly attributed to the normalization of Japanese automobile production and the stability of semiconductor-related exports against the backdrop of moderate global economic growth.

The number of foreign tourists has returned to pre-pandemic levels

The number of foreign tourists traveling to Japan has returned to 2019 levels in 2024. Goldman Sachs expects that by 2025, the number of foreign tourists will transition to a more normal trend, with an expected annual growth rate of 7%.

Monetary Policy Continues Normalization

In 2024, the Bank of Japan will raise the benchmark interest rate from -0.1% to between 0% and 0.1%, ending an eight-year period of negative interest rates. This policy change marks the official abandonment of negative interest rate policies and yield curve control by the Bank of Japan, signaling the end of large-scale economic stimulus. However, the rate hike actions are swift but limited in scope, indicating that the Bank of Japan's rate hike policy is being implemented gradually.

At the same time, next year's positive inflation and economic outlook will support continued rate hikes.

Goldman Sachs expects that the Bank of Japan will raise interest rates by 25 basis points in January and July of next year, with the policy rate reaching 0.75% by the end of 2025, and will continue to raise rates, reaching a terminal rate of 1.5% by 2027. If the yen depreciates to around 160 yen against the dollar, the next rate hike may be advanced from January 2025 to December 2024 The normalization of monetary policy may have an impact on Japan and even the global financial markets, especially for those arbitrage trades that rely on Japan's low-cost funds.

Corporate profits continue to improve, TOPIX is expected to rise above 3100 points

This year, despite foreign investors net selling 5.1 trillion yen, the Japanese stock market has remained resilient, mainly due to the positive attitude of individual investors and companies towards the stock market and an increase in stock buybacks. Looking ahead to 2025, Goldman Sachs expects the TOPIX index to achieve positive returns for the third consecutive year.

Specifically, Goldman Sachs expects that the benchmark index of the Japanese stock market—the TOPIX index is likely to rise to 3100 points in the next year, which is 14.2% higher than Monday's closing price. So far this year, the index has accumulated a rise of over 14%.

Returns will primarily be driven by profit growth rather than valuation expansion. Over the past decade, corporate profits have essentially stagnated, and Goldman Sachs believes that after a period of expectations for policy and corporate governance reforms, it is now time to see these policies and reforms reflected in actual performance.

Goldman Sachs expects the earnings per share (EPS) of TOPIX to grow by 30% in the fiscal years 2024-2026, with a price-to-earnings ratio of 14.3 times. Goldman Sachs wrote:

We expect the target price-to-earnings ratio to only expand moderately, with most of the upside coming from earnings per share growth. This price-to-earnings ratio should be achieved through stable net inflows from foreign investors, individuals, and companies.

Goldman Sachs believes that for investors focused on company fundamentals, attention should be paid to industries that show significant differences in growth potential, market valuation, or shareholder engagement, especially those industries that demonstrate attractiveness from a bottom-up analysis of individual companies.

Focus on five major investment themes: normalization of monetary policy, Japanese stocks heavily influenced by China, geopolitical issues, corporate transformation, and beneficiaries of AI in Japan.