By Mustafa Sagun, Chief Investment Officer, Principal Global Equities
In another effort to jump-start the stagnant Japanese economy, the Bank of Japan (BoJ) unexpectedly announced on January 29th that it was cutting its benchmark interest rate to -0.1%. The negative rate applies only to excess balances that exceed reserve requirements, thereby encouraging banks to increase their loans (risk-taking) in order to avoid the negative rate. Cash currently held at the central bank will continue to earn the same 0.1% interest as before, while required reserves will now earn zero interest. The BoJ also left the door open for further movement into negative territory or expansion of the monetary base 'if judged as necessary.'
The interest rate move came right after one of the key architects of Abenomics, Minister of State for Economic Revitalization Akira Amari, resigned from his cabinet post amid a political donation scandal. The bank's message to the government seemingly appears to be that "Once again, we are doing whatever it takes. It's time for you to do your job." The Abe government had been pressing for BoJ action and made public statements supporting the move.
Assuming banks keep balances at the BoJ, the earnings impact to the banks is relatively modest at -4-5% on average. This impact does not include benefits from a potentially weaker yen for the mega-banks such as Mitsubishi UFJ Financial Group, Inc. (NYSE:MTU), Sumitomo Mitsui Financial Group, Inc. (NYSE:SMFG), and Mizuho Financial Group (NYSE:MFG). At the same time, some estimates for domestic banks like Resona and other regional banks is in the high single and low double digits. In addition, if this move signals the resolve of the BoJ to "do what it takes," cross shareholding values of the mega-banks are likely to move higher, thereby allowing them to continue unwinding at higher values. We'd also point out that while Japan's Financial Services Authority has encouraged and pushed for regional bank mergers, we've only seen three cases so far. While banks were comfortable with a slow drop in net interest margin year over year, the new negative rate could mean a high, double-digit net interest margin drop for banks with mostly domestic loan exposure. We believe this may be a short-term opportunity for financials in Japan, as stock prices have heavily discounted these potential negatives and then some. However, we have to recognize that although Japan has been used to a low-rate environment over the past 20 years, investor psychology of having negative rates is different than low rates and this tool may create unintended consequences and investor behavior.
As always, the unintended consequences of actions are of interest and warrant a closer examination. First, by resorting to negative interest rates, the BoJ is losing or has lost any powerful means to help the real economy and is essentially admitting the ineffectiveness of additional quantitative easing. Case in point is the European Central Bank, which is still struggling with deflationary pressure. Negative rates won't fix the fundamental problem of weak demand for loans and capital expenditures. Despite continuing to provide available low-cost funding, loan demand hasn't risen in Japan (or around the world either for that matter). And why should it? In a previous blog post, I wrote about the minimal impact of the third round of quantitative easing in the United States. More specifically, that the large, negative 'real' rates have not helped to spur capital expenditures nor the demand for loans substantially. It will be interesting to see if negative rates spur growth in Japan.
In the United States, the U.S. Federal Reserve (Fed) also sent a "negative rate" signal in January that concerned bank analysts. When the Fed published its Comprehensive Capital Analysis and Review stress-test scenarios for U.S. banks regarding sensitivity of their capital requirements, the down-market scenario included a test that had negative short-term interest rates in the United States! Also, the high inflation scenario from the previous year was removed. Analysts' first response was to think that even the Fed is thinking about negative rates as an option when the next U.S. recession hits, joining the international club of countries using negative rates as a tool. Financial shares were sold off in the United States as investors weighed the risks of rising credit losses coupled with negative rates which would erode banks' earnings very quickly. However, the Fed came back quickly and explained that the negative rate stress-test scenario was put in place to address U.S. banks that have international exposure because more countries are promoting negative rates as a policy tool and it won't directly apply to the United States. Despite this assertion, investors remain concerned about whether the United States will see a recession in 2016 triggered by deflationary forces, and if so, will the Fed respond with a negative interest rate policy since it's running out of stimulus options?
We don't believe a negative interest rate policy is implementable in the United States because of the $3 trillion money market industry. The money market funds potentially breaking the buck would create bigger problems in the economy than the intended stimulus that negative rates would create. For now, although negative rates are out of question in the United States, increased credit risks and potential defaults could still erode banks' earnings. This is why we believe investors should proceed with caution when picking stocks within banks. Not all banks are equal, it's important to understand the difference in the quality of their credit exposure, their regional footprint, and their consumer versus commercial business mix. Having a better understanding of these factors could help an investor differentiate the winners from the losers as the credit cycle turns.
Negative yields are becoming all too common: $6 trillion of global bonds have negative yields. Over 57% of both German and Japanese bonds are trading with negative yields. This lack-of-return situation becomes a challenge for global investors, but it makes bond-like equities, such as high dividend paying, stable, quality companies, look more attractive in this yield-starved environment.