Citi: Japan's stock market will be able to recover by the end of the year

Citi analysts believe that Japan's stock market will be able to recover by the end of 2026. According to the investment bank's assessment, the sharp sell-off on November 6 reflected an economic downturn in stock prices that Citi itself does not expect to materialize.

According to the bank, current prices could only be justified if both the global and Japanese economies were to enter a clear recession. One possible precondition for this would be a reduction in US investment in artificial intelligence and data centers.

What caused the decline in Japanese stocks?

In early November, Japan's stock market recorded a significant decline. Over the course of the month, the Nikkei 225 index fell by more than 7%.

Investor concerns were linked both to the potential impact of the US midterm elections on regulation of the artificial intelligence and data center sector, and to the prospect of further interest rate hikes by Japan's central bank.

The Bank of Japan officially declared victory over deflation, which reinforced expectations of further monetary policy tightening. As a result, the stock decline spread beyond the technology sector to other areas of the market. According to Citi's assessment, this suggests that investors were anticipating a deterioration not only in technology companies but in the economy and corporate profits as a whole.

Citi believes the market is pricing in an overly pessimistic scenario

According to Citi's calculations, the earnings per share (EPS) implied by closing prices on November 6 was roughly 20% below the current market consensus forecast. This implied an almost 30% decline in the aggregate EPS of Japanese companies for fiscal year 2027.

According to the bank, a decline in earnings of more than 20%, or a drop of more than 30%, has historically been recorded only during periods of recession.

Expectations for the technology sector were particularly stark. Based on the MSCI Japan IT index, the market was pricing in a year-on-year decline of more than 50% in the sector's EPS for fiscal year 2027. Citi considers this estimate exaggerated.

The technology sector accounts for only about 23% of the TOPIX index. Accordingly, in Citi's view, even if technology companies' profits were to be cut in half, it would be difficult to envision a decline of more than 30% in the EPS of the Japanese market as a whole, provided other sectors remain stable.

Why does Citi expect a market recovery?

Citi notes that pessimistic expectations of similar magnitude for Japanese stocks have formed in the past as well, including during the 2025 tariff shock. In such cases, analysts' profit forecasts gradually declined, but the expectations reflected in market prices improved relatively quickly, followed by a recovery in stocks.

The bank does not rule out that Japan's stock market may continue to experience high volatility in the near term. Nevertheless, its base-case scenario remains unchanged: Japanese stock prices will begin to recover toward the end of the year.