Asia has been identified correctly as the most vulnerable region to both the Iran War and Trump 2.0 tariffs. Overall, recent financial market performance has reflected these risks (next Chart). Indeed, equities in most Asian countries have lagged global and US indices, and most regional currencies have weakened.

Perhaps surprisingly, however, Japan has been an exception. Indeed, the Nikkei index has soared in the past year, and the yen has remained relatively stable in 2026, despite surging oil prices. Japan’s economic resilience has reflected its ability to strengthen non-US trading links, its successful pre-war preparations for higher oil quotes, and its flexible macro-policy management.

However, the limits of Japan’s resilience will be tested the longer the disruption in global energy supplies continues. Indeed, the Bank of Japan’s recent forecast changes — reducing its GDP estimate from 1% to 0.5% in 2026, and raising its inflation projection from 1.9% to 2.8% — may signal the economy is entering a trickier phase.

Despite the recent benign April CPI result, the inflationary impact of higher energy prices may be greater in Japan than in other countries. And, while the BOJ (like other central banks) will need to juggle the combination of weaker GDP growth and higher prices, Japanese interest rates may rise three times this year. Even so, financial conditions will remain more relaxed than in other major markets. As a result, preventing further modest JPY weakness may prove difficult, despite recent FX intervention.

Impressive Economic Resilience

To be sure, US tariffs have limited Japanese exports to its previously largest trading partner. Nevertheless, overall sales abroad advanced nearly 12% in the past year, as trade with other Asian nations and Europe have expanded robustly (Chart above). Meanwhile, the collapse in exports to the Middle East (not a large partner, fortunately) illustrates goods are neither leaving nor entering the Strait of Hormuz.

Meanwhile, some expected Japan to be amongst the most vulnerable to the closure of the key Gulf waterway. Indeed, the imported share of Japan’s energy usage is the highest in the world (Chart above).

In recent decades, however, Japan has improved its energy efficiency considerably (Chart above). Indeed, Japan produces more output per unit of energy than the USA and other Asian nations. In other words, Japan requires less energy to produce each unit of GDP. As a result, Japan’s energy imports as a percent of GDP are lower than most Asian nations, although higher than the USA and Europe (next Chart).

Macro-Policy Flexibility: Financial Conditions Very Loose

Another reason behind Japan’s recent economic resilience is the continuation of the loosest financial conditions amongst the G20 countries. For example, despite the BOJ’s efforts to begin normalising monetary policy, real interest rates remain the lowest in the world, and well below the neutral rate (next Chart).

In addition, despite the high level of government liabilities, Japan has reduced its debt to GDP ratio in recent years. Following her landslide electoral victory, however, Prime Minister Takaichi has signaled her intention to stimulate fiscal policy to offset the impact on households of higher energy prices. Japan does not typically use energy subsidies. However, these price supports where used to cushion the impact on consumers during the Ukraine war, and could be implemented again (Chart below).

A legacy of the BOJ’s earlier attempts to battle deflation with negative interest rates is that the Japanese yen is the world’s most undervalued currency (Chart below).

While Japan’s very relaxed financial conditions have contributed to its recent economic resilience and soaring equity valuations, I believe this may add to inflation risks. Indeed, the inflationary consequences of higher oil prices may be greater than elsewhere. Recent BOJ currency intervention aimed at preventing JPY weakness from adding to price pressures. Ultimately, however, higher interest rates will be required. To be sure, I expect three hikes this year; nevertheless, monetary conditions will remain accommodating. The BOJ’s cautious approach to juggling growth and inflation considerations is unlikely to prevent a modest JPY depreciation in the months ahead.

Reaching a Tipping Point?

Given the scarity of domestic energy sources, Japan maintains larger oil inventories than other energy-dependent Asian and European countries (Chart above). Japan’s shrewd pre-war energy supply management has contributed to its recent economic resilience.

However, there are limits to this strategy. To be sure, crude oil stockpiles could last up to six months. However, inventories of refined products are already being depleted, which is occurring throughout Asia and Europe. Moreover, inventories of natural gas will be more quickly depleted than for oil (Chart above).

In addition to coping with the oil “price shock”, Japan is especially vulnerable to the “supply shock” resulting from the closure of the Strait of Hormuz. To be sure, all Asian nations are dependent on Middle East oil supplies. However, nearly all of Japan’s oil imports come from Gulf states (Chart above). Fortunately, Japan’s sources of LNG are more diverisified, including reliable supplies from the USA and Australia (Chart below).

Overall, Japan’s resilience will be tested the longer the Strait of Hormuz remains closed. Japan has manged the situation well, but I fear they are nearing a tipping point.

Long-Term Structural Challenges

In addition to the growth and inflation problems posed by higher energy prices, Japan confronts formidable challenges to its long-term economic prospects. Especially in the absence of steady immigration, Japan’s declining population limits labour supply and GDP growth potential. Critically, therefore, Japan must rely on productivity growth.

However, Japan’s efficiency not only lags other OECD nations, but the gap has widened in recent decades (Chart above). During Japan’s deflationary era, stagnant productivity contributed to weak real income and consumption growth. Large-scale investment in AI, automation, robotics, etc. will be needed to boost productivity, and deal with labour scarcity.

Japan’s future energy security (and the achievement of Net Zero commitments) would benefit from reduced reliance on fossil fuels, which account for 75% of electricity generation (Chart above). Despite increased usage of renewables, Japan lags Europe, China, and the USA on sustainable energy sources (Chart above). In addition, coal’s renewed use after the Fukushima disaster is likely to give way to a return of nuclear power in the future.

Finally, Japan’s aging population will pose huge challenges to the nation’s public sector finances. And, despite the recent decline in the government debt ratio, Japan enters this era with the largest debt burden amongst G20 countries (Chart above).

Tipping Point: Valuations are Not Cheap

As the resilience of Japan’s economy may be approaching a tipping point, Japanese equities are not cheap. Indeed, only the AI-fueled Korean and Taiwanese markets are more expensive in Asia (Chart above).