Nikkei 225 analysis: AI rally, stretched valuations and carry trade risk

Nikkei 225's 30% year-to-date surge: AI-driven outperformance versus the broader TOPIX

The Nikkei 225 has surged approximately 30% year-to-date, decisively outpacing the TOPIX, which has gained around 14% over the same period. The divergence is largely a function of index construction methodology. The Nikkei 225's price-weighted structure has amplified the outsized contributions from a concentrated cluster of high-priced, AI-linked constituents, while the broader TOPIX — spanning more than 2,000 constituents on a market-capitalisation-weighted basis — captures a more measured picture of Japan's equity market.

At the sector level, technology stocks have led the advance, with materials and financials also among the standout performers. The sector-level framing, however, understates the dominance of the AI theme. A significant proportion of the year's strongest performers across non-technology industries by conventional classification derive a meaningful share of their earnings from the artificial intelligence (AI) supply chain. Resonac, a chemical manufacturer commanding a dominant global market share in advanced packaging materials and epoxy moulding compounds (EMC) used in semiconductors, has gained approximately 154% year-to-date. Mitsui Kinzoku, whose copper foil underpins high-end packaging substrates, has advanced around 124%. Their outperformance reflects a structural re-rating of companies embedded in the AI hardware buildout.

Nikkei 225 year-to-date sector returns, based on market cap-weighted average

Stretched valuations leave limited margin for error: Nikkei 225 and TOPIX

The market's gains have been accompanied by a material re-rating in valuation multiples. The Nikkei 225 now trades at 22.7x forward earnings, and the TOPIX at 16.7x — both in excess of one standard deviation above their respective 10-year historical averages. Both indices also carry a premium to the broader regional benchmark, with the MSCI AC Asia-Pacific index trading at 14.0x forward earnings. 

Earnings growth provides some fundamental underpinning for the optimism. Calendar first-quarter (Q1) 2026 results showed year-on-year (YoY) profit growth of approximately 14% across TOPIX constituents — a respectable performance in absolute terms. However, the aggregate result came in roughly 12% below analyst expectations, constituting a meaningful miss. By comparison, S&P 500 constituents delivered an 8% positive earnings surprise over the same reporting period. The more constructive signal is that forward estimates for Japanese corporates have been revised upward by approximately 3% for the coming quarter, indicating that analysts retain confidence in the earnings growth trajectory. At current multiples, however, the margin for disappointment is narrow.

Price-to-earnings ratios of TOPIX and peers

BoJ policy uncertainty and the carry trade risk: echoes of August 2024

The macro backdrop is further complicated by the Bank of Japan's (BoJ) evolving policy trajectory. At the April meeting, three of the nine board members voted to raise rates — the most divided outcome since 2016. Governor Ueda has since sharpened his tone, cautioning that a temporary energy shock can become entrenched if it feeds through to wages, inflation expectations, and broader price-setting behaviour. A 25-basis point rate increase at the 15–16 June policy meeting now appears highly probable absent a material escalation in the prevailing conflict.

The more consequential question is what follows the June decision. Market participants are currently divided on whether the BoJ will proceed with additional rate hikes in the months ahead. Should the Bank adopt a hawkish tone signalling a higher probability of further tightening to address inflation and yen weakness, the risk of a sharp unwinding of global carry trades would rise significantly. Carry trades involve borrowing a lower-yielding currency — in this instance the yen — to fund positions in higher-yielding assets elsewhere, with returns derived from the interest rate differential.

Commodity Futures Trading Commission (CFTC) data on speculative positioning shows net short yen positions at $10.1 billion — a level last observed in July 2024, when coordinated Japanese government intervention triggered an initial carry trade unwind that was subsequently and dramatically accelerated by the BoJ's rate hike on 31 July of that year.

The structural setup closely resembles the 2024 episode. With the yen funding a substantial volume of cross-currency positions, a more aggressive tightening path than markets currently anticipate carries the potential to inflict significant collateral damage well beyond Japan's borders — as demonstrated in August 2024.

CFTC speculative traders' net long USD/JPY positions ($ billion) versus USD/JPY

Technical analysis: Japan 225 pullback may be a healthy reset before a new high

Following an advance of 36% from its late-March lows to a peak of 68,758, the Japan 225 index has undergone a material correction since last week, pulling back to test immediate support at the uptrend line near 63,000.

Despite the sharp decline, a retracement following a rapid advance constitutes a healthy reset for the index. The medium-term uptrend remains technically intact provided the index continues to hold above the 200-day moving average (MA). In the near term, further consolidation is plausible, with potential downside towards the 38.2% Fibonacci retracement of the preceding up-wave near 61,800 — a level that also coincides with a 10% correction from the peak. Should that support hold, the conditions would be in place for a retest of the historic high following a period of base-building.

Japan 225 daily price chart

The figures stated in this article are as of 9 June 2026 unless otherwise stated. Past performance is not a reliable indicator of future performance. This report does not contain and is not to be taken as containing any financial product advice or financial product recommendation.