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Japan Investment Strategy
Nikkei to 20,000: Inventory cycle upturn →
cyclicals; inflation → banks, insurance
Investment Strategy 18 November 2016
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Bullish equities 2017; rotation into cyclicals, banks, insurance
We are bullish Japan equities for 2017 and we estimate the Nikkei 225 index will recover
to 20,000 by end-2017 (see $/¥’s eventual surge: Buy Nikkei 06 September 2016). Our
new Chief Japan Economist Izumi Devalier forecasts above-consensus Japan GDP growth
and inflation in 2017, which is also supportive of our bullish equities scenario (see Ready
for ignition 18 November 2016). We expect rotation into cyclicals, banks and insurance
as explained below.
1) Upturn in inventory cycle: Defensives→Cyclicals
We expect cyclicals to outperform defensives, premised on our end-2017 $/¥ estimate
of ¥120, and this is supported by our above-consensus economic growth outlook. Our
Japan economist sees a shift to fiscal easing, firms countering the tight labor market by
increasing capex, and estimates industrial production to grow 3.5% and 3.6% in 2017
and 2018, respectively. With the inventory cycle exiting a “contraction” phase and
entering a “recovery” phase, conditions are likely to remain conducive to cyclicals
outperforming defensives (Chart 1, Exhibit 3).
2) Higher inflation, rates: Deflation stocks→Inflation stocks
Up to 1H16, the Japan equity market saw continued preference for deflationary stocks
as domestic inflation remained subdued and the JGB curve underwent excessive bull
flattening. Defensives outperformed cyclicals (Chart 1), growth outperformed value
(Chart 2), and stocks that benefit from a low-yield environment (REITs) outperformed
the converse (banks, insurance; Chart 3). However, we expect conditions to reverse into
2017. We see US Treasury yields rising and Japanese core CPI inflation recovering to
+1.4% yoy by 2018 and core-core to +1.1% yoy. Stronger inflation and higher foreign
yields should steepen the JGB yield curve above10yr, while below 10yr should escape
from downward pressure as BoJ rate cut expectations recede. Against this backdrop, we
expect to see a rotation from deflation to inflation stocks, which in addition to cyclicals
means banks and insurance should outperform REITs within the financial sector (Chart 3).
This is also in line with the global rotation expected by Michael Hartnett (The Flow
Show: The Inflation Era Begins 10 November 2016).
3) Nikkei winner of steeper UST and strong macro
In a scenario of strong external demand and US rate hikes (particularly with curve
steepening), Japan equities tend to be the winner on a local currency basis, led by
cyclicals, banks and insurance stocks (Exhibit 4). Resurgence in the “Japan macro trade”
of short yen / buy equities is also a possibility.
Our Buy-rated stocks in bank, insurance and cyclical sectors are listed in Table 1.
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Refer to important disclosures on page 5 to 6. 11687576
Timestamp: 17 November 2016 03:30PM EST
Investment Strategy
Japan
Shusuke Yamada, CFA >>
FX/Equity Strategist
Merrill Lynch (Japan)
+81 3 6225 8515
shusuke.yamada@baml.com
Exhibit 1: Sector rotation and inventory
cycle
Slowdown
Defensives
8
6
June '15 4
Inventory
2
June '14
Fundamentals
Production
0
(8) (6) (4) (2) 0 2 4 6 8 10
(2)
Sep '16
June '13 (4)
Contraction
Cyclicals
(6)
Expansion
June '12
Recovery
Source: BofA Merrill Lynch Global Research, Bloomberg,
Haver
Exhibit 2: Shares rated Buy by our
analysts in cyclical, bank and insurance
sectors*
Company Ticker Company Ticker Company Ticker
Mitsubishi UFJ
8306 JP Dai-ichi Life 8750 JP JR East 9020 JP
FG
Japan Post
7182 JP
MS&AD
8725 JP JR Central 9022 JP
Bank
Holdings
SMFG 8316 JP
Sompo
8630 JP Nintendo 7974 JP
Holdings
Resona HD 8308 JP
Shin-Etsu
4063 JP Recruit HD 6098 JP
Chem
Mitsubishi Elec 6503 JP FUJIFILM 4901 JP Oriental Land 4661 JP
Nidec 6594 JP Sony 6758 JP Fuji Heavy Ind 7270 JP
Hitachi 6501 JP NTT DATA 9613 JP Suzuki Motor 7269 JP
Panasonic 6752 JP NSSMC 5401 JP
Source: BofA Merrill Lynch Global Research
*Market cap above 1.5trn JPY except bank, insurance
shares
Risks: Geopolitics, diplomacy and US economic cycle
The biggest risk to our scenario is the implications for Japan’s diplomatic and
geopolitical environment of the Donald Trump presidency in the US. The likelihood of
agreement on the TPP (Trans-Pacific Partnership) has already declined and been priced
into the market, but any downward spiral in Japan-US relations would likely be further
negative for Japan equities near-term. A rise in protectionism would be negative for
stocks with high US export exposure. Meanwhile if the US economy slows or enters
recession and the protectionist response weakens USD, it would be negative for
Japanese cyclicals, particularly exporters, due to stronger JPY and potential trade
conflicts. Moreover, a potential improvement in US-Russia (US-China) relations under
the new US President most likely implies a relative worsening in Japan-Russia (Japan-
China) relations. On the other hand, we expect Japan to move closer to Europe under
such a scenario, raising the incentive to sign the Japan-EU EPA (Economic Partner
Agreement), positive for related stocks. If the Trump presidency tips the US towards
isolationism, we expect Japan’s spending on defense to increase. If this results in higher
spending on Japan’s Self Defense Forces (rather than compensating for US spending on
Japan-based US military), Japan’s defense-related stocks would be beneficiaries, and it
could reshape the arms industry in Japan.
Chart 1: Sector rotation and inventory cycle
130.0
40
125.0
120.0
30
115.0
20
110.0
10
105.0
100.0
0
95.0
-10
90.0
85.0 Cyclical Fundamental Defensive Cyclical Fundamental Defensive
-20
Cyclical
80.0
-30
Jan-09 Jan-11 Jan-13 Jan-15
Industrial production - inventory (3m mva yoy%)
MSCI Japan cyclical/defensive
Source: BofA Merrill Lynch Global Research, Bloomberg, Haver
Cyclical = Industrials, consumer discretionary, IT, materials
Defensive = Healthcare, telecom, consumer staples, utilities
Calculated cyclical and defensive % change using monthly index return and index weight
Chart 2: Japan – High Beta PB vs. Low Beta PB
High Beta PB / Low Beta PB
2.0
1.8
1.6
1.4
1.2
1.0
0.8
0.6
0.4
0.2
90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17
Source: BofA Merrill Lynch Global Quantitative Strategy, MSCI, IBES
Global Quant Panorama: Surf for longer 14 November 2016
2 Japan Investment Strategy | 18 November 2016
Exhibit 3: Sector rotation and inventory cycle
Slowdown
Inventory
Expansion
8
Defensives
6
June '12
June '15 4
2
June '14
Fundamentals
Production
0
(8) (6) (4) (2) 0 2 4 6 8 10
(2)
Sep '16
June '13 (4)
Chart 3: Higher inflation/yields suggests banks will outperform REITs
2.3
2.1
1.9
1.7
1.5
1.3
1.1
0.9
0.7
0.5
Contraction
Cyclicals
(6)
Recovery
TSE Bank/ TSE REIT
Source: BofA Merrill Lynch Global Research, Bloomberg,
Source: BofA Merrill Lynch Global Research, Bloomberg, Haver
Exhibit 4: Reactions to US Treasury curve moves (%, simple average of past 43 quarters) – Japan equities have outperformed during bear-steepening led by
cyclicals, banks and insurance
12
10
8
6
4
2
0
-2
-4
-6
-8
-10
-12
USDJPY DXY MSCI JP MSCI JP /
ex JP
Japan Sector = cyclical outperform on
UST bear-steepening
Discretionary Financials Materials IT Industrials Energy Telecom Staples Utilities Health care
Bear steep Bear flat Bull steep Bull flat
Source: BofA Merrill Lynch Global Research, Bloomberg.
Curve movements based on 2yr move and 2s10s move (Bloomberg US Treasury yield index), so includes twist movements, but even if we exclude these implications do not materially change.
Bear steepening (2yr + 16bps, 2s10s +33bps) = 11 quarters, bear flattening (2yr +26bps, 2s10s -20bps) = 10 quarters, bull steepening (2yr -48bps, 2s10s +28bps) = 10 quarters, bull flattening (2yr -27bps, 2s10s -30bps) =
12 quarters
Japan Investment Strategy | 18 November 2016 3
Table 1: Shares rated buy by our analysts in cyclical, bank and insurance sectors*
Company Name Ticker Industry (JPX definition) Price
MKT CAP
(Billion Yen)
Analyst Name
Mitsubishi UFJ FG 8306 JP Banks 683 9,674 Futoshi Sasaki
Japan Post Bank 7182 JP Banks 1331 5,990 Futoshi Sasaki
SMFG 8316 JP Banks 4190 5,925 Futoshi Sasaki
Resona HD 8308 JP Banks 538 1,251 Futoshi Sasaki
Mitsubishi Elec 6503 JP Electric Appliances 1592 3,418 Mikio Hirakawa
Nidec 6594 JP Electric Appliances 10460 3,035 Masashi Kubota
Hitachi 6501 JP Electric Appliances 588 2,658 Mikio Hirakawa
Panasonic 6752 JP Electric Appliances 1033 2,533 Mikio Hirakawa
Dai-ichi Life 8750 JP Insurance 1850 2,202 Futoshi Sasaki
MS&AD Holdings 8725 JP Insurance 3405 2,085 Futoshi Sasaki
Sompo Holdings 8630 JP Insurance 3684 1,506 Futoshi Sasaki
Shin-Etsu Chem 4063 JP Chemicals 8328 3,599 Takashi Enomoto
FUJIFILM 4901 JP Chemicals 4095 1,906 Hiroyasu Eguchi
Sony 6758 JP Electric Appliances 3226 4,075 Mikio Hirakawa
NTT DATA 9613 JP Information & Communication 5530 1,551 Hiroyasu Eguchi
NSSMC 5401 JP Iron & Steel 2384 2,266 Takashi Enomoto
JR East 9020 JP Land Transportation 9542 3,743 Yasuhito Tsuchiya
JR Central 9022 JP Land Transportation 17825 3,672 Yasuhito Tsuchiya
Nintendo 7974 JP Other Products 26050 3,129 Hiroyasu Eguchi
Recruit HD 6098 JP Services 4340 2,453 Yoshiyuki Kinoshita
Oriental Land 4661 JP Services 5957 1,991 Rie Sakai
Fuji Heavy Ind 7270 JP Transportation Equipment 4320 3,371 Kei Nihonyanagi
Suzuki Motor 7269 JP Transportation Equipment 3711 1,637 Kei Nihonyanagi
Source: BofA Merrill Lynch Global Research
*Cyclical sectors = Industrials, consumer discretionary, IT, materials in GICS definition
*Market cap above 1.5trn JPY except bank, insurance shares
*Exclude Fast Retailing
4 Japan Investment Strategy | 18 November 2016
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6 Japan Investment Strategy | 18 November 2016