Thoughts from the Road: Japan

I recently traveled to Japan to meet with CEOs, policymakers, and investors as well as to spend time with our KKR colleagues on the ground. We continue to view Japan as one of the more underappreciated corporate reform stories among global investors. In our view, it is without question one of the most fertile markets for active ownership, particularly for Private Equity, to ‘make your own luck’ through operational improvement, strategic repositioning and, increasingly, employee ownership. The good news for long-term investors is that for those who have not participated, it is not too late. Indeed, while Japan has made great strides in recent years, our simple DuPont analysis (which we show in Exhibit 17) suggests that capital structures, margins, and asset turnover can all still be improved meaningfully to drive ROE even higher.

From a macro perspective, I left Tokyo with greater conviction that Japan is essentially ‘ground zero’ for our Regime Change thesis of policy-inspired higher nominal GDP growth across the developed markets. Interestingly, because of the consequential change from deflation to inflation in recent years, Japan is one of the few markets where Equities appreciate in a higher nominal GDP environment at the same time that bond values depreciate. One can see this in Exhibit 1.

EXHIBIT 1: Japanese Equities Have Been Rising Alongside Higher JGB Yields…

Japan: Equities vs. Bond Yields

EXHIBIT 2: …Amidst a Stronger Nominal GDP Growth Environment in Japan

Japan Nominal GDP Growth, Rolling 3-Year Average

Importantly, beyond digging deeper into the corporate reform story in Japan (where we detail several positives as well as one concern emerging around a potential new proposal that many view as too subjective regarding criteria for takeovers), my trip also revealed several macro insights that I think warrant investor attention. They are as follows:

• A quiet but important shift is underway in the sources of funding. As Japan moves from deflation to inflation, the traditional deposit base is no longer growing in the same way relative to the credit capacity needed to support the capex ambitions of ‘Sanaenomics’ (Exhibit 3). In our view, that is a meaningful development and one that should be constructive for non-bank lenders and Private Credit providers as corporates increasingly turn to markets and private solutions for financing.
• Real estate looks underappreciated, especially in a higher inflation regime. With a ‘higher resting heart rate’ for inflation, Japan’s real estate market may be undervalued, in our view. CPI escalators are becoming more standard in contracts, replacement costs are moving well above underlying asset values, and many corporates still have not optimized their real estate footprints, an opportunity set that could widen as governance reforms continue to pressure balance sheets and capital allocation.
• AI is a necessity, not a threat, in Japan. Unlike in the United States, in Japan there is essentially no anxiety about AI helping drive corporate productivity. In fact, it is a must-have, not a nice-to-have. Indeed, Japan’s demographic burden is driving acute labor shortages across multiple industries, especially as capex ramps up and the demand for services accelerates. At the same time, a weak currency is boosting demand for services (for example, getting a seat in a hotel lobby in Tokyo was nearly impossible due to foreign tourists, many of them couples and families). This combination means that AI and automation are increasingly required to sustain growth. As we detail below, productivity gains, including by robots and automation and programming logic, are required for policy framework success.
• Our constructive outlook is predicated on the currency holding at around 160 JPY/USD and rates not moving up too fast. Both geopolitics and monetary policy represent potential headwinds to the reform story, especially if energy and food prices stay too high for too long or rates move up too quickly or the currency weakens too much. Importantly, companies across all of Asia are starting to feel the pinch of commodity shortages, so our on-the-ground observations are not just theoretical in nature. It is a delicate balancing act as our Regime Change model is being realized at a time of heightened geopolitical conflict. The good news is that, as we discuss below, we do think Japan’s government has time to increase productivity before long rates move up to 3.0%. However, the public and private sectors need to work together to reassure the market regarding the execution of the government’s ‘hotter for longer’ economic strategy.

Overall, though, we remain positive on deploying capital across both public and private markets in Japan. Negative real rates, bold administrative policy, unwavering rule of law, and ongoing corporate reforms are creating a constructive setup that, in our view, outweighs the drumbeat of geopolitical tensions, Private Credit concerns, or any broader fears around AI disintermediation.

EXHIBIT 3: Deposits Are Shrinking Relative to the Balance Sheet, Which Means More Non-Bank Lending Is Needed in Japan

Japanese Banks, Deposits to Assets Ratio, %

EXHIBIT 4: Real Estate Is Still Undervalued Amid a Higher-Inflation Regime

Japan: Inflation, Equity, and Real Estate Price (2020=100)

However, our trip to Tokyo, including time spent in Paris with business leaders and clients immediately following our Japan trip, also revealed some of the negative shocks that the global economy, Asia and Europe in particular, are facing (many of which may be hard to fully appreciate sitting in the United States; see Exhibit 26). Beyond the tragic human element of the Iranian war, supply chains are being dented again (somewhat similar to COVID, where it was more about availability than even price). Indeed, while much of the media focus has been on oil transportation through the Strait of Hormuz, we would just highlight that we heard multiple stories about Asian and European companies being short inputs such as helium and plastics. Fertilizers are also being withheld, and we do expect issues surrounding LNG in short order. Just consider, for example, that Taiwan only has 11 days of LNG inventory for its semiconductors at TSMC (which uses 10% of that country’s total power). Beyond near-term breakeven yields, it also feels to us that parts of the capital markets are not fully discounting a more prolonged ‘higher for longer’, geopolitically-driven backdrop (Exhibit 7).

EXHIBIT 5: We Think 2026 Will Remain a Higher Inflation Environment and That Our Regime Change Narrative Will Continue

Low and High Growth and Inflation Regimes

EXHIBIT 6: National Security Is Now Bundled With Rule of Law and Economics/Trade, and Wrapped in the Complexity of Digitalization

Blurring of Lines Across Economics, Rule of Law, and National Security

EXHIBIT 7: Crude Oil, LNG, Credit Spreads, and the S&P 500 All Feel a Little Optimistic, in Our View

Comparison of Ongoing Iran Conflict with Other Recent Market Dislocations

We also spent time during our trip with thought leaders close to central bankers. The recent tone of commentary supports our view that the global easing campaign has largely run its course, which represents a change in our thinking. Importantly, if the Iran conflict stretches for months rather than weeks, the risk is that inflation pressures remain elevated for longer, tightening the Fed’s reaction at the margin. Outside the U.S., the winds of change are already upon us. Specifically, we have already begun to see a more hawkish tilt, including a hike from the RBA and signals from both the ECB and the BoE that they are prepared to hike if inflation proves sticky (see Exhibit 8).

EXHIBIT 8: We Have Now Passed the Point of Peak Global Easing

Percent of Top 25 Global Central Banks Hiking Rates

Looking at the big picture, we are still in a Regime Change environment that requires a different mindset for asset allocation, including the traditional relationship between stocks and bonds. Moreover, as we laid out in our Outlook (see Outlook for 2026: High Grading), we are advocating at this point in the cycle for investors to consider ‘High Grading’ their portfolios against today’s more volatile environment. The reality is that the cost to upgrade one’s portfolio now is quite low relative to history. Meanwhile, we believe that there are several key investment themes on which one should focus. These include the Security of Everything (importantly, the Iranian conflict is going to drive more demand from CEOs for redundancy capacity and supply chain resiliency), Capital Heavy to Capital Light, Productivity/Worker Retraining, and Services (more on this below).