Japan emerged as a standout performer in the global financial landscape in 2025, and economic analysts project this positive momentum to extend well into 2026. The nation is experiencing a robust reflationary phase, marked by synchronized growth in economic output, wages, and prices. In response, the Bank of Japan has taken a significant step by raising interest rates to their highest level in three decades—a move interpreted by many as a strong vote of confidence in the economy's underlying resilience against global headwinds and trade tariffs.
Drivers of Japan's Market Outperformance
The benchmark Nikkei 225 index has gained an impressive 26% year-to-date in 2025, significantly outpacing the S&P 500's 17% rise. This strength is notable as it occurred without the typical tailwind of a sharply weakening yen, which has historically boosted exporter profits. For the year, the yen has remained largely flat against the US dollar.
Two primary factors are credited for this market vigor. First, Japan maintains a critical position in the global technology supply chain, allowing it to capitalise on the widespread optimism surrounding artificial intelligence (AI). Second, and perhaps more foundational, are the successful corporate governance reforms initiated during former Prime Minister Shinzo Abe's tenure from 2012 to 2020. These reforms have substantially improved corporate efficiency and shareholder returns, making Japanese equities more attractive to global investors.
Addressing the Debt Concern: A Manageable Burden
The most frequently cited risk for Japan is its enormous public debt, which stands at approximately 200% of Gross Domestic Product (GDP). Adding to this, yields on Japanese Government Bonds (JGBs) have risen in 2025, with the 10-year yield jumping from 1.09% to 2.08% and the 30-year yield climbing from 2.28% to 3.43%.
However, experts argue these concerns are manageable. Thomas Mathews of Capital Economics points out that the average duration of Japan's government debt is over nine years, compared to about six years in the US. This means rising yields only gradually affect the government's financing costs as old debt rolls over slowly. Furthermore, Japan's high debt ratio stems more from decades of deflation and stagnant nominal GDP shrinking the denominator of the debt-to-GDP equation, rather than reckless fiscal spending.
Critically, this trend has reversed. Nominal GDP growth has averaged 3.1% over the past four years, actively reducing the debt-to-GDP ratio from 212% in 2022 to around 200% currently. Capital Economics notes that Japan is now deleveraging faster than any other major advanced economy.
Strategic Fiscal Stimulus Under Prime Minister Takaichi
The fiscal policy of newly installed Prime Minister Sanae Takaichi is also viewed constructively. Her stimulus package, valued at around 3.4% of GDP according to Fitch Ratings, is not merely populist. It strategically allocates funds to sectors like semiconductors and shipbuilding, where global competitors are also investing, and raises defence spending to 2% of GDP—a reasonable adjustment given regional security dynamics.
Some observers have worried that rising JGB yields could pull Japanese domestic savings away from funding the US deficit, impacting US Treasury markets. Yet, this fear seems contradictory to the narrative of Japan's own debt troubles. Moreover, while Japan's 10-year yield rose about a percentage point in 2025, the equivalent US Treasury yield fell by roughly 0.4 percentage points, indicating broader, domestically-driven forces at play in American markets.
In conclusion, the perceived risks to Japan's economic story appear overstated. The combination of structural reforms, strategic fiscal policy, and a virtuous cycle of nominal growth provides a solid foundation. For investors looking to diversify beyond US markets in 2026, Japan presents one of the most compelling opportunities for continued growth and returns.
