Political Uncertainty in Japan: Implications for Equity and Bond Markets

Political uncertainty in Japan has reached a critical juncture, driven by the potential unraveling of the Liberal Democratic Party (LDP)–Komeito coalition. This instability, fueled by Komeito's internal struggles and the LDP's rightward shift under Sanae Takaichi's leadership, is reshaping the investment landscape for equities and bonds. As Japan grapples with fiscal sustainability, corporate governance reforms, and trade policy shifts, sectoral risks and opportunities are emerging with distinct implications for investors.

Equity Markets: Resilience Amid Structural Reforms

Japanese equities have demonstrated resilience despite political headwinds, supported by structural reforms and improved corporate governance. According to a Lombardodier report, Japanese companies are generating robust free cash flow, enabling increased dividends and buybacks, which have bolstered investor confidence. The Nikkei 225 index has risen by 11% since July 2025, reflecting optimism around earnings growth and capital allocation improvements, according to an Invesco outlook.

However, sectoral disparities are emerging. Infrastructure and defense stocks are poised to benefit from expanded fiscal stimulus, including a ¥50 trillion ($330 billion USD) infrastructure investment plan proposed by Takaichi, according to a CNBC report. Similarly, technology and energy resilience sectors are gaining traction as the government prioritizes AI and national security, a Saxo analysis notes. Conversely, export-dependent industries face headwinds from a strengthening yen, which could erode profit margins despite the Bank of Japan's (BoJ) cautious normalization of monetary policy, according to Lombardodier.

Corporate governance reforms, such as enhanced shareholder oversight and capital efficiency measures, remain a tailwind. The Tokyo Stock Exchange's initiatives since 2023 have nearly doubled share-buyback announcements in 2024, signaling a shift toward value creation, according to Invesco. Yet, political fragmentation may delay further reforms, creating volatility for sectors reliant on policy continuity.

Bond Markets: Volatility and Fiscal Risks

The bond market is under heightened pressure as political uncertainty amplifies concerns about Japan's fiscal sustainability. Japanese government bond (JGB) yields have surged, with 10-year yields climbing above 1.58% and 30-year yields nearing 3%, a trend highlighted by Saxo. This upward trend reflects investor anxiety over potential fiscal stimulus and the BoJ's policy path. Life insurers-major JGB holders-have turned net sellers, signaling a loss of confidence in yield stability, according to CNBC.

The LDP's emphasis on expansive fiscal measures, including tax cuts and cash transfers, raises questions about Japan's ability to manage its 240.6% GDP debt ratio, a point underscored by Invesco. While Takaichi's pro-growth agenda supports short-term economic momentum, it risks exacerbating inflationary pressures and prompting sharper monetary tightening. The BoJ's exit from negative interest rates in 2024 has already contributed to rising borrowing costs, and further normalization could deepen volatility in long-end yields, as Lombardodier observes.

Trade and Policy Shifts: Navigating a Fragmented Landscape

The LDP's minority government status has introduced delays in trade policy decisions, particularly for the Japan-U.S. trade deal, which requires Diet approval, according to The Diplomat. Opposition parties, such as the Democratic Party for the People (DPFP), are pushing for tax concessions and consumption tax reductions, complicating fiscal planning for defense and foreign policy initiatives, The Diplomat reports. These dynamics may benefit sectors like healthcare and renewable energy, driven by demographic and green technology trends, while export-oriented industries face regulatory uncertainty.

Corporate governance reforms are also evolving under the new political reality. Proposals for third-party monitoring of political funds and stricter corporate donation transparency could reshape investor perceptions, particularly in sectors with high lobbying activity, according to The Diplomat.

Conclusion: Balancing Risks and Opportunities

Investors must navigate a dual narrative in Japan's markets: structural reforms and political fragility. Equities in infrastructure, technology, and energy resilience sectors offer growth potential, while bond markets face elevated risks from fiscal expansion and inflationary pressures. The BoJ's policy trajectory and the LDP's ability to maintain a coherent agenda will be critical in determining market stability.

As Komeito's potential exit looms, the focus remains on policy continuity and fiscal discipline. For now, Japan's strong domestic savings and current account surplus provide a buffer, but prolonged uncertainty could test investor patience. Sector-specific strategies-hedging against yen volatility, capitalizing on governance-driven value creation, and monitoring yield curve dynamics-will be essential for navigating this complex environment.