Navigating Trade Uncertainty: The Resilience of Japan's Domestic Demand and Its Implications for Japanese Equities

Japan's economy has long been shaped by its dual reliance on export-driven industries and a vast domestic service sector. However, the past two years have revealed a stark divergence in performance between these two pillars. While export-linked sectors—particularly automotive, machinery, and electronics—have struggled with trade barriers, supply chain disruptions, and global demand volatility, Japan's service sector and capital spending have demonstrated remarkable resilience. This shift is not merely a short-term anomaly but a structural reorientation that is reshaping the investment landscape. For equity investors, the implications are clear: sectors tied to domestic demand, especially inbound tourism, hospitality, and retail, are outperforming their export-dependent counterparts, offering compelling opportunities for selective investing.

The Service Sector: A Beacon of Stability

Japan's service sector, which accounts for 71.4% of GDP, has become a stabilizing force amid global trade tensions. In Q1 2025, the sector expanded at a 0.6% annualized rate, driven by robust domestic demand and a rebound in inbound tourism. The au Jibun Bank Japan Services PMI rose to 51.7 in June 2025, reflecting three consecutive months of growth and a business climate marked by expansion plans and hiring. This resilience is underpinned by a tight labor market, with unemployment at 2.5%, and government initiatives to boost domestic consumption, such as tax-free shopping programs and regional tourism campaigns.

Inbound tourism, in particular, has emerged as a standout performer. In 2024, Japan welcomed 36.9 million international visitors—a 16% increase over pre-pandemic levels—generating JPY 8.1 trillion (USD 53.3 billion) in spending. This surge has directly benefited hospitality and retail, with major metropolitan areas like Tokyo, Osaka, and Aichi capturing 70% of tourist activity. The Japan Tourism Agency's (JTA) focus on regional tourism, including immersive experiences and luxury travel, has further diversified revenue streams. By 2030, the JTA aims to attract 60 million visitors and generate JPY 15 trillion in tourism-related spending, a target that underscores the sector's long-term potential.

Capital Spending: A Surprising Growth Engine

Capital spending, often a lagging indicator of economic health, has defied expectations in 2025. In Q2, Japan's capital expenditure grew by 1.3% year-on-year, far exceeding the 0.5% forecast. This growth was driven by investments in software, urban redevelopment, and green infrastructure, supported by government subsidies and corporate confidence. The Bank of Japan's Tankan survey revealed that large firms plan to increase investment by 11.5% in the current fiscal year, signaling a shift toward domestic innovation and sustainability.

This surge in capital spending has offset the drag from export-linked sectors. For instance, while automotive exports to the U.S. fell 24.7% year-on-year in May 2025 due to 25% tariffs, domestic investment in machinery and technology has remained strong. The resilience of capital spending is a critical factor for equity investors, as it reflects Japan's ability to pivot toward self-sustaining growth models.

Export Sectors: Struggling with Global Headwinds

In contrast, Japan's export sectors face mounting challenges. The automotive industry, once a cornerstone of the economy, has been hit by U.S. tariffs, production halts (e.g., Toyota's certification scandal), and China's shift toward domestic EV production. In 2024, industrial output fell 2.3% year-on-year, with machinery and electronics exports declining as global demand waned. The Nikkei 225's industrial and manufacturing indices have lagged behind service-sector counterparts, reflecting these pressures.

Moreover, the U.S.-Japan trade tensions under President Donald Trump's administration have introduced further uncertainty. Tariffs on Japanese auto exports and the threat of additional barriers have dampened corporate confidence, with forward-looking PMI indicators remaining subdued. While Japan's R&D capabilities and global brand strength in manufacturing remain formidable, the sector's growth trajectory is contingent on resolving trade disputes and stabilizing global demand.

Equity Market Implications: Where to Invest

For investors, the divergence between domestic and export sectors presents clear opportunities. Equities in tourism, hospitality, and retail are outperforming, driven by sustained demand and government support. Key beneficiaries include:
- Tourism and Hospitality: Companies like Japan Travel, ANA Holdings, and regional hotel chains (e.g., Hoshinoya) are capitalizing on the inbound tourism boom.
- Retail and E-commerce: Uniqlo (Fast Retailing) and luxury brands like Takashimaya are leveraging Japan's reputation for quality and innovation.
- Capital Goods and Green Tech: Firms involved in urban redevelopment (e.g., Mori Building) and renewable energy (e.g., SoftBank Energy) are positioned to benefit from government subsidies and corporate investment.

Conversely, export-dependent sectors like automotive and machinery require caution. While Toyota and Honda remain industry leaders, their growth is contingent on trade resolutions and global market conditions. Investors should prioritize companies with diversified supply chains and strong domestic demand exposure.

Conclusion: A New Era for Japanese Equities

Japan's economic narrative is evolving. The resilience of domestic demand, particularly in the service sector, has created a new axis of growth that is less vulnerable to global trade volatility. For equity investors, this shift represents a strategic inflection point: sectors tied to tourism, hospitality, and capital spending offer compelling long-term opportunities, while export-linked industries require careful risk management. As the Bank of Japan continues to normalize monetary policy and the government invests in domestic innovation, the path forward for Japanese equities is one of selective optimism.