By Daisuke Nomoto, Senior Portfolio Manager
Last week, the Bank of Japan (BoJ) announced that it would push interest rates below zero on some current account balances made by commercial banks. The decision was controversial (5-4 vote) and came as a big surprise to the markets, especially since BoJ Governor Kuroda had maintained that negative rates were off the table. The rate reduction will strengthen the current QQE program (quantitative and qualitative monetary easing), which is purchasing long-term Japanese government bonds (JGBs) to maintain the nation's monetary base at an annual pace of 80 trillion yen. More importantly, the BoJ's announcement that it would cut interest rates further into negative territory if necessary should spur depreciation of the yen, which we view as positive for Japanese equities.
How does the new policy work?
The new design includes exemption thresholds for liquidity, much like the Swiss National Bank, which adopted a negative rate in 2014. Currently, Japanese banks earn 0% on the required reserve in the BoJ's current account balances and +0.1% on the excess reserve. Under the new system, existing balances in both the required reserve (basic balance) and excess reserve (macro add-on balance) remain subject to those respective rates. However, -0.1% will be earned on the so-called policy rate balance. According to the BoJ, the reason for this multi-tier system is to "prevent an excessive decrease in financial institutions' earnings stemming from the implementation of negative interest rates that could weaken their functions as financial intermediaries."
Exhibit 1: A multi-tier interest rate system
Implications for the market
Many investors had been worried about the technical limits of the QQE program, with the BoJ widely perceived as the whale in the JGB market. The announcement of the implementation of negative interest rates should alleviate investor concerns about the limitations of the BoJ's easing program; the announcement should also build confidence that the BoJ still has many tools to further ease monetary policy in order to reach its 2% inflation objective.
Although Governor Kuroda said the BoJ was not targeting the currency, the new measure will weaken the yen. A falling yen is clearly positive to the Japanese equity market. If the yen holds at around ¥120 against the USD, then this should make the earnings growth rate of Japanese companies look more attractive, particularly in a globally low-growth environment. The negative interest rate should also cement expectations that inflation will eventually reach 2% and accelerate the "from savings to investments" trend, moving household financial assets from bank deposits (worth more than 50% of ¥1700 trillion of the household financial assets) towards risk assets like stocks and bonds. The other implication is that wages will have to rise in real terms, which is one of the keys for the success of Abenomics.
However, the new policy may be hard on Japanese banks, which have fewer interest earning opportunities due to lower JGB yields across the horizon. We don't anticipate credit growth to be significantly boosted by cutting rates below zero. In fact, the negative rate policy that Europe started in 2014 has failed to substantially boost credit growth. Given the lack of loan growth opportunities, Japanese banks may have to choose from the following three options: 1) Consolidate the industry to gain market share and pricing power; 2) Increase investment in Japanese REITs to earn 3-4% dividend yields; or 3) Increase foreign bond purchases, which would allow the yen to keep falling without the BoJ having to use its own capital.
A falling yen represents a reversal from the recent appreciation caused by the global market risk-off (investors see the Japanese yen as a safe haven currency). This could be negative for China's currency, because yen depreciation increases the relative value of the Chinese renminbi, which is pegged to the SDR basket in principle. Chinese policymakers may have to start planning a little more aggressive currency devaluation. Also, exporters in countries like Taiwan and Korea who make similar products that Japanese exporters produce may lose relative price-competitiveness.
Outlook for Japanese equities
Consensus earnings growth estimates for Japanese companies don't look overly aggressive at around 8-10%, leaving 2016 PE multiples of 13x and a PB multiple of only 1.2x. Given the relative attractiveness both on earnings growth opportunities and valuation, we remain positive on Japanese equities. Corporate governance reform can be a powerful force to make Japanese companies more shareholder-friendly. Cash/market cap of Japanese companies (ex-financials) is about 30% (versus 8% for the S&P 500) and net debt/equity is 14% (versus 120% for the S&P 500) - this suggests that Japanese companies have ample ability to conduct more share buybacks, dividend hikes and M&As. During extremely tough deflationary environments, they can cut fixed costs to bring down their breakeven ratios. This is important because a low breakeven ratio makes it possible for companies to generate reasonably strong profits even with fractional sales growth, i.e., in a low-growth environment like right now.
Within Japan, the immediate beneficiaries of negative rates include exporters and high-dividend stocks like REITs, while banks will be in a tough spot. All that being said, our approach is not simply to buy up these sectors/companies, but to continue focusing on finding mispriced securities based on our stock-specific research. We currently see opportunities in five areas: 1) Companies which can increase content value per product; 2) A dominant player to help arrange M&As for mom-and-pop companies looking for successors (aging population theme); 3) Robotics and automation; 4) Outsourcing; and 5) Reformers of Japan's inefficient distribution structure (eliminating middlemen in the value chain).
As for how the new policy will impact broader central bank policy, I will leave that to my colleagues. However, I believe last week's announcement reaffirms the BoJ's strong commitment to reaching its 2% inflation target, while demonstrating that it has some more levers to pull. Although controversial, I believe this policy should provide the Japanese economy and equity market with more positives than negatives. We remain optimistic and encourage investors to look for opportunities in high-quality Japanese companies to take advantage of the recent sell-off.
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