PEC’s Japan strategy：Through the Looking-Glass

Please refer to page 67 for important disclosures and analyst certification, or on our website www.macquarie.com/research/disclosures. ASIA “The time has come,” the Walrus said, “To talk of many things: Of shoes-and ships-and sealing wax- Of cabbages-and kings- And why the sea is boiling hot- And whether pigs have wings” Lewis Carroll, Through the Looking-Glass TOPIX and MSCI AC Asia-ex (in US$, indexed to 100 as of start 2011) Source: FactSet, Macquarie Research, February 2016 Our TOPIX 12-month target is 1670, 15.0 times earnings to December 2017 (111). TOPIX at 1350 is on 13.2 times our FY3/16E EPS of 102. Analyst(s) Peter Eadon-Clarke +81 3 3512 7850 peter.eadon-clarke@macquarie.com Nara Song +81 3 3512 7878 nara.song@macquarie.com 10 February 2016 Macquarie Capital Securities (Japan) Limited PEC’s Japan strategy Through the Looking-Glass Whilst the BOJ introduced negative interest rates on a sliver of banking industry current deposits kept at the BOJ, on 29 January 2016, the JGB market at the end of that day offered guaranteed losses, negative yields, out to eight years, below. The 10-year JGB yield went negative on 9 February 2016. Japanese yields (negative yields highlighted in pale red) 3m 6m 1y 2y 3y 4y 5y 6y 7y 8y 9y 10y 20y 30yr 01/2016 -0.03 -0.08 -0.07 -0.07 -0.07 -0.06 -0.07 -0.08 -0.05 -0.02 0.03 0.10 0.81 1.20 12/2015 -0.03 -0.09 -0.05 -0.01 -0.01 0.00 0.03 0.03 0.07 0.11 0.18 0.27 1.00 1.28 12/2014 0.01 -0.01 -0.02 -0.02 -0.02 -0.01 0.03 0.03 0.10 0.16 0.23 0.33 1.06 1.27 12/2013 0.06 0.06 0.09 0.09 0.10 0.18 0.25 0.30 0.46 0.56 0.65 0.74 1.59 1.73 12/2012 0.11 0.11 0.10 0.10 0.10 0.12 0.19 0.25 0.39 0.53 0.67 0.79 1.75 1.97 Source: Bloomberg, Macquarie Research, February 2016 Investor confusion is widespread. With the BOJ increasing its JGB holdings by ¥80tr a year, and Japan’s fiscal deficit being around ¥35tr (= the annual net JGB issuance), then existing JGB holders are selling ¥45tr a year at very high bond prices. Effectively, the only net buyer at the current extraordinary low yields is the BOJ. The BOJ is targeting the whole yield curve, seeking an average remaining maturity on its holdings of 7-12 years. The BOJ is inducing a portfolio rebalancing. For the banking system, the incentives are to a) increase lending such that excess reserves become required reserves, and the bank has more earning assets, b) grow overseas to dilute the Japanese operations, c) consolidate at home to realise cost efficiencies. For the non-bank private sector, the JGB market is indicating that the BOJ will go beyond its existing policy, and the BOJ has stated its willingness to do so if necessary. Broadly, we would expect the banking industry to start passing on negative interest rates to institutional/corporate deposits if the BOJ reaches -50bp, and to retail deposits if the BOJ reaches -100bp. To avoid losses in both real and nominal terms, the non-bank private sector is incentivised to switch to other assets. We believe all of the categories below will benefit, and that land, property & infrastructure assets could see the largest flows. For more, please see the 3 February 2016 PEC’s Japan strategy: The BOJ & Reflation winners. Japan’s non-bank private sector’s need to take more risk Overseas bonds Currency risk increasing, we forecast a mild trend appreciation of the yen, Credit risk increasing in emerging market and corporate markets MNCs (global equities) Diversified earnings stream, 2-3% dividend yield, dominant brands, technology leaders, strong balance sheets. Nonetheless, in addition to currency valuation risk, global equities are a volatile asset class Land, property & infrastructure assets Land values in Japan are opaque, but are a leveraged beneficiary of falling property cap rates. Investment properties/infrastructure offer secure running yield, and have increasing domestic regulatory support Overseas M&A Corporate Japan’s top choice: 9 December 2015 Corporate behaviours Source: Macquarie Research, February 2016 Follow the Money: inside, we look at investor flows within the Japanese equity market. We expect a diversity of willing domestic buyers to support the market. 70809010011012013001/1107/1101/1207/1201/1307/1301/1407/1401/1507/1501/16MSCI AC As ia ex J PTOPIX(Jan'11=100) Macquarie Research PEC’s Japan strategy 10 February 2016 2 Follow the Money This is our regular examination of bottom-up investor flows, attempting to provide insights into the behavioural drivers for each major investor category. Page 6: A diversity of foreign investors Page 17: The BOJ, GPIF, Japan Post Page 28: Individual activity & IPOs, NISAs Page 46: Secondary activity Page 53: Banks and their cross-shareholdings Page 56: Other domestic institutions Page 62: Summary and conclusions As we wrote last week in the 3 February 2016 PEC’s Japan strategy: The BOJ & reflation winners, we suspect that the current very low market share of TSE turnover by individuals is a cause for