asia pec’s japan strategypg.jrj.com.cn/acc/res/cn_res/invest/2016/1/20/a284833d... · 2016. 1....

Please refer to page 46 for important disclosures and analyst certification, or on our website

www.macquarie.com/research/disclosures.

ASIA

TOPIX, 2014 start to latest (in Yen)

Note: High 1,691 14 January 2016

Source: FactSet, Macquarie Research, January 2016

TOPIX and MSCI AC Asia-ex (in US$, indexed to 100 as of start 2011)


Analyst(s) Peter Eadon-Clarke +81 3 3512 7850 [email protected] Nara Song +81 3 3512 7878 [email protected]

20 January 2016 Macquarie Capital Securities (Japan) Limited

PEC’s Japan strategy Policy choices and TOPIX We believe that Japanese policy remains supportive of the bull view.

Corporate revitalisation has been achieved, and fiscal reconstruction is well

advanced. From April 2017, we expect the policy priority to shift convincingly to

monetary reflation, defined as self-reinforcing domestic demand growth.

This optimistic view just requires the continuation of existing policies.

Policy choices: We have long argued that policy is essential to TOPIX

forecasting, e.g. the 23 January 2008 So much for dividend yield: the market

responds to policy, not value (one from the archives). Unfortunately, prior to

2013 there has been a long winter of poor policy. We detailed Japan’s 1990-

2002 vicious cycle of policy and regulatory mistakes in the 12 January 2016

Macq-ro insights: Diminishing “Japanization” fears. There was another period of

premature domestic tightening in 2006, in our opinion, and whilst 2011 was the

year of disasters (earthquake, tsunami, Fukushima), policy was very slow to

respond. Given this history, it is prudent to watch policy carefully.

A crab-like walk, TOPIX 1993 to latest

Note: Major domestic disappointments occurred in 1997, 2006 and 2011, as explained in the 4 March 2015 PEC’s Japan strategy: A history of market vulnerabilities. The Global Financial Crisis hit over 2008-09.


Our TOPIX 12-month target is 1,670 (unchanged), 15.0 times earnings to

December 2017 (111). Being cyclically advanced, TOPIX earnings growth is

forecast to be around 6% pa. We are forecasting the ¥/US$ to begin a mild trend

appreciation. TOPIX at 1400 is on 13.7 times our FY3/16E EPS of 102. Please

see the 13 January 2016 PEC’s Japan strategy: Stocks, themes & sectors for

our intra-asset class recommendations.

We’ve rolled our earnings forward three months, and reflected a revision to our

¥/US$ forecasts (the Yen is forecast to be ¥2 stronger each year over 2016-18).

Japanese real GDP growth and ¥/US$ forecasts (Macquarie)

CY11 CY12 CY13 CY14 CY15E CY16E CY17E CY18E CY19E

GDP (YoY, %) -0.5 1.7 1.6 -0.1 0.5 1.1 0.5 0.3 0.8

¥/$ (end year) 77.6 86.3 105.4 119.8 120.4 118 114 110 104

Source: Bloomberg, Macquarie Research, January 2016

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Macquarie Research PEC’s Japan strategy

20 January 2016 2

Policy choices and TOPIX There follow sections on: a) Japanese policy priorities, b) the outlook for the Yen, c) the

outlook for TOPIX earnings, d) our TOPIX target price.

The executive summary is: a) corporate revitalization, fiscal reconstruction, monetary reflation

– in that order, b) starting a mild trend appreciation, c) 6% p.a. on a trend basis, d) in line with

earnings delivery.

Fig 1 Japan: key macroeconomic forecasts

CY11 CY12 CY13 CY14 CY15E CY16E CY17E CY18E CY19E

GDP (YoY, %) -0.5 1.7 1.6 -0.1 0.5 1.1 0.5 0.3 0.8

CPI (YoY, %) -0.3 0.0 0.4 2.7 0.4 0.5 1.4 1.1 1.2

Overnight call rate (*) 0.1 0.1 0.0 0.1 0.1 0.1 0.1 0.3 0.5

10-year JGB (*) 0.99 0.79 0.74 0.3 0.2 0.6 0.8 1.2 1.2

¥/$ (*) 77.6 86.3 105.4 119.8 120.4 118 114 110 104

Note: CPI is the headline CPI ex fresh foods. (*): per period end, Macquarie forecasts. The ¥/$ forecasts for 2016-18 have all been reduced by ¥2 in the 18 January 2016 The Global Macro Outlook: Divergences become Chasms #2. Source: Bloomberg, Macquarie Research, January 2016

Where might surprises appear from?

We have not changed our macroeconomic forecasts for Japan since the 7 October 2015

PEC’s Japan strategy: Clipping our Japan forecasts again. As the title of that report implies,

2015 saw us clip our real GDP growth forecasts twice, with the first cut made in the 26 August

2015 PEC’s Japan strategy: Clipping our Japan forecasts.

The principal catalyst for the downward revisions was the weak summer bonus season, with

disappointing household income growth leading to a weaker consumption forecast. Since a

mild recovery in consumption is the main driver of the faster growth we are forecasting for

2016, Fig 1, we are watching nervously for indications of the winter bonus season and the

spring base wage negotiations.

Fig 2 Real GDP growth forecasts for 2015-16

Macquarie: 2015 2016 Consensus: 2015 2016

Real GDP growth 0.5 1.1 0.6 1.2

Note: Consensus numbers are from Consensus Economics 7 December 2015

Source: Consensus Economics, Macquarie Research, January 2016

Our 2017-19 Japanese real GDP growth forecasts are 0.5%, 0.3% and 0.8% respectively,

with the April 2017 increase in the consumption tax rate expected to push Japanese growth

beneath our estimate of Japan’s trend growth rate of 0.8% pa for two years (2017-18).

The above is not inspiring. Japanese companies are generally recycling the improved profits

from a weak Yen (and sticky US$ pricing) into internationalisation. 2015 was a record year for

In-Out M&A. Please see the 9 December 2015 PEC’s Japan strategy: Corporate behaviours

for 111 pages of analysis of the drivers of corporate cash-flow choices.

The importance of economic growth to PM Abe

The revealed policy priorities of the Abe administration are outlined over pages 5-21. The

political pressure on PM Abe will be importantly determined on 24 January (this coming

Sunday) with the Ginowan, Okinawa mayoral election. Military base locations and the new

security laws are expected to dominate. To avoid a typical mid-term protest vote in the July

2016 Upper House election, we are expecting PM Abe to dissolve the Lower House in order

to hold joint elections. Whilst this will dilute the electorate’s focus on constitutional, security,

media freedom, and individual human rights issues, it will increase the importance of the

economy’s doing well over the next 6-9 months.

We expect Japan to ratify the TPP agreement in the spring (April, May), with considerable

financial assistance given to rural interests.

The executive

summary

We are watching

nervously for

indications of the

winter bonus

season and the

spring base wage

negotiations

Constitutional,

security, media

freedom, and

individual human

rights issues


20 January 2016 3

The “Abenomics” recovery is highlighted in Fig 3, grey highlights. Net of the mid-2014

recession, Fig 4 grey highlights, cumulative so far has been 2.8%.

In comparison, the moderate, but sustained growth under PM Koizumi is highlighted in pale

red. Real growth grew 11.4%. This was also the time of the global credit boom.

Fig 3 Cumulative rate of growth in real GDP and its component contribution breakdown during non-recession periods since 2Q 1994

Real GDP

Private consumption

expenditure Housing CAPEX Inventory Public

cons Public

inv Net

exports Exports Imports

1994.2Q-1997.3Q 6.0 3.0 -0.3 2.3 0.2 1.2 0.1 -0.2 2.0 -2.3 1998.3Q-2001.1Q 3.4 1.9 0.1 0.3 0.1 1.7 0.3 -0.4 1.1 -1.9 2002.2Q-2008.1Q 11.4 6.1 -1.1 2.1 0.0 3.9 -1.9 2.9 8.2 -5.2 2009.2Q-2010.3Q 7.6 3.0 -0.6 -0.2 0.6 0.9 0.3 3.7 5.5 -1.6 2011.3Q-2012.1Q 5.0 2.0 0.3 1.3 0.4 1.3 0.5 -0.2 3.1 -3.2 2013.1Q-2014.1Q 3.5 2.8 0.4 1.1 -0.8 0.3 0.6 -0.7 2.0 -2.6 2014.4Q-2015.3Q 1.6 0.4 0.3 0.2 0.3 0.4 0.0 0.2 0.6 -0.4

Note: Other periods apart from those with a minimum of two back to back negative quarter on quarters, please see Fig 4

Source: Cabinet Office, Macquarie Research, January 2016

Fig 4 Cumulative rate of decline in real GDP and its component contributions during recessions since 4Q 1997

Real GDP

Private consumption

expenditure Housing CAPEX Inventory Public

cons Public

inv Net

exports Exports Imports

1997.4Q-1998.2Q -2.5 -0.6 -0.3 -0.8 -0.6 0.3 -1.0 0.5 -0.3 0.7 2001.2Q-2002.1Q -1.6 0.5 -0.3 -1.1 -1.0 0.6 -0.6 0.4 -0.3 0.7 2008.2Q-2009.1Q -9.5 -2.2 0.0 -2.3 -1.0 0.1 -0.2 -4.0 -7.1 3.2 2010.4Q-2011.2Q -3.1 -0.6 0.0 -0.2 -0.9 0.2 -0.1 -1.5 -1.2 -0.3 2012.2Q-2012.4Q -1.1 0.2 0.2 0.0 -0.3 0.1 -0.3 -1.0 -1.2 0.1 2014.2Q-2014.3Q -2.3 -3.0 -0.6 -0.6 0.7 0.1 0.1 1.0 0.4 0.7

Note: A minimum of two back to back negative quarter on quarters

Source: Cabinet Office, Macquarie research, January 2016

The contribution to the 11.4% PM Koizumi growth period from private consumption

expenditure was 6.1%. The contribution to the 2.8% “Abenomics” recovery from private

consumption expenditure has been just 0.2% so far. Nonetheless, PM Abe’s popularity has

recovered a little from its summer 2015 security agenda related plunge, chart below.

Fig 5 Support for the Abe cabinet, January 2013 to latest, % in favour

Source: Asahi Shimbun, Nikkei, Macquarie Research, January 2016

The changing four horsemen of the apocalypse

For the two decade up until 2013 Japanese equity investors were faced with four domestic

horsemen of the apocalypse: 1) Bad demographics, 2) Deflation, 3) Poor corporate

governance, 4) Policy passivity. These headwinds have greatly diminished.

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Asahi - Approval Nikkei - Approval(%)

PM Abe’s popularity

has recovered a

little from its

summer 2015

security agenda

related plunge


20 January 2016 4

1) The Bad demographics of an aging society, shrinking working population is now

less feared. The Affluent Elderly is now our leading theme (13 January 2016 PEC’s

Japan strategy: Stocks, themes & sectors, page 12), and due to people working

beyond 65 and greater female participation rates, the number of Japanese employed

has been broadly stable for 20 years.

2) Deflation is ending, though the BOJ target of 2% CPI on a sustained basis is not yet

in sight. Marginal increases in nominal base wages are an early sign of the end of

the “deflationary mentality”.

3) Poor corporate governance is slowly improving under government initiatives.

Please see the 9 December 2015 PEC’s Japan strategy: Corporate behaviours.

4) Policy passivity is now in the past. Please see this report, and the 12 January 2016

Macq-ro insights: Diminishing “Japanization” fears.

Instead of four domestic horsemen of the apocalypse, Japanese equity investors now face

four international horsemen of the apocalypse: 1) Oil, 2) Credit, c) China, 4) The Fed.

1) The plunge in the Oil price is undermining the finances of producer states, leading to

shrinking sovereign wealth funds (SWFs), and having a second round effect into bad

debts down the oil/resources supply chain. Advanced economies, and Japan in

particular, being net energy importers, consumers, are beneficiaries. The BOJ

estimates that the CPI is around 1% lower as a consequence, Fig.19, to the benefit

of real household incomes.

2) The negative consequences for credit quality down the oil/resources supply chain

noted above also have a positive offset as advanced economies’ private sectors

credit demand picks up. Please see the 18 January 2016 The Global Macro Outlook:

Divergences become chasms #2. We believe that again Japan is a net beneficiary

with less exposure to bad credits than the positives that flow from the ongoing 3-4%

pa growth in domestic bank lending.

3) China concerns come in many forms, but a loss of control of the currency by the

authorities would have severely negative consequences for global stability. We are

forecasting the fade in China’s real GDP growth to continue. We appreciate the

distrust of official statistics by most investors. We believe auto sales monthly data is

quite clean, and it is currently supportive of our ongoing fade forecast, rather than the

hard-landing scenario. We believe Chinese policy-makers have both the willingness

and ability to maintain control of the RMB. Our house views are already built into our

Japanese export volume and TOPIX EPS forecasts.

4) The Fed is able to increase its policy rate because private sector credit growth has

been growing since 2011, and has been growing faster than US nominal GDP growth

since early 2015. As the 18 January 2016 The Global Macro Outlook: Divergences

become chasms #2 notes:

We expect the US monetary tightening cycle to be gradual, cautious, and supportive of risk-

taking. This suggests an ongoing “policy put” will remain in place for 2016-17, though in a

different form. In the quarters ahead, any economic slowdowns or disruptive volatility in

markets amidst tightening are likely to be responded to by delaying or pausing further

tightening.

From a Japan perspective the expectation of investors appears to have been from increasing

Fed funds into 10-year bond yields, and spreads with 10-year JGBs, into another leg-down in

the ¥/US$. We are forecasting a mild appreciating trend in the Yen, which is also already built

into our TOPIX EPS forecasts. The cycle high 10-year US bond yield is forecast to be just

2.7%, as the fed policy nudges growth slower and the yield curve flattens.

The US$ in 2016: After a period of broad US$ strength in 2015, we believe 2016 will see

individual currencies at different times pass their lows versus the US$. Whilst relative

monetary policy stances will remain important, resulting capital flows now have to exceed

mounting current account surpluses in Japan and the Euro-zone (partially reflecting the falls

in oil and other resource prices). On our forecasts the Yen bottoms first, and then the Euro

(2Q 2016).

Japanese equity

investors now face

four international

horsemen of the

apocalypse

The four domestic

horsemen of the

apocalypse


20 January 2016 5

Japanese policy priorities Believing that Japan macro is “Abenomics” and that Abenomics is about monetary reflation,

most investors are negative on Japan because after 3 years of Abenomics there is still no

self-reinforcing domestic demand driven growth engine.

In our opinion, this view misses a critical reality, the revealed policy preferences of the ruling

LDP government. There appears to be three key objectives, Fig 6.

We believe that both corporate revitalisation and fiscal reconstruction are more important

government priorities than monetary reflation. As a consequence, on our forecasts, monetary

reflation is a seven year program, through into 2019.

For equity investors, Fig 6 could be interpreted very bullishly as: strong earnings growth

(corporate revitalization), a diminishing equity risk premium (fiscal reconstruction) and

supportive monetary policy through 2019 on our forecasts (monetary reflation).

Fig 6 Japan’s top three policy objectives (with the benefit of hindsight)

Government policies Corporate

revitalisation Fiscal

reconstruction Monetary

reflation (*)

1) Financial repression (flattening the yield curve, negative real rates, benefitting debtors at the expense of savers)

Positive Positive Negative

2) Weak currency (sticky US$ prices leading to surging profits, imported inflation erodes real household income)

Positive Neutral Negative

3) Consumption tax rate increases offset by increased public expenditures Neutral Positive Negative

4) Structural reform (TPP is still pending ratification, but expected consequences would include foreign competition in domestic Japan, improved capital efficiency, the elimination of small low ROE companies, labour relocation)

(Positive) (Neutral) (Negative, until the dislocation aspect is overwhelmed by

inward FDI)

Note: (*) defined as a self-reinforcing domestic demand driven growth engine rather the BOJ’s 2% on a durable basis CPI target

Source: Macquarie Research, January 2016

The strongest argument in favour of our position, we believe, is that the household sector is

“paying” for corporate revitalisation and fiscal sustainability through a reduction in its share of

GDP, as illustrated in Fig 7 (red line). This is a major impediment to monetary reflation.

Fig 7 Household consumption to GDP vs. Japan’s REER

Note: The vertical dotted lines relate to the 1989 consumption tax introduction (at 3%), and the subsequent increases: 1997 to 5%, 2014 to 8%. We’ve included movements in Japan’s real effective exchange rate (REER) in the chart above. Whilst moves down in the Yen can be thought of as a tax on consumers (higher import prices) to the benefit of producers, it is more complicated than this. Initially, a pick-up in the corporate sector could involve increased overtime hours, employment, and bonus payments leading to higher household income. Nonetheless, with the exception of the early 1980s, a weakening of the Yen appears associated with a declining share of consumption in GDP

Source: Cabinet Office, BIS, Macquarie Research, January 2016

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The revealed policy

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20 January 2016 6

Weak consumption is one of the principal causes, along with companies favouring profits over

cutting their US$ export prices, why the BOJ’s QQE program is expected to last into 2019.

At 59% of Japan’s 2013 real GDP, private consumption expenditure is a key component of

any Japanese real GDP growth forecast.

Revitalisation of the corporate sector and fiscal reconstruction

We believe that an income transfer is at the core of “Abenomics”, with the household sector

expected to bear the burden of the revitalisation of the corporate sector (via the weak yen,

and negative real borrowing costs) and fiscal reconstruction (consumption tax rate increases,

pension benefit cuts, negative real interest rates on JGBs).

Negative real interest rates benefit borrowers (the government, the corporate sector) at the

expense of the savers (the household sector). This policy is known as financial repression.

Over 2002-07 the ratio of consumption expenditure to GDP fell 3%, from 58.5% to 55.5%.

The decline was a steady 0.5% pa, Fig 7, red line. We are forecasting a broadly similar 3%

decline in the household consumption to GDP share over 2014-18.

Over 2014-18 we are forecasting cumulative real GDP growth of 2.3% and real consumption

and residential investment growth of -0.4%, implying a 2.7% decline in the household share.

Fiscal reconstruction

Fig 8 shows how Japan’s public debt to GDP has far exceeded the previous high in 1945, and

is still growing. Fig 9 shows how Japan’s public debt to GDP ratio has built over the last 24

years, from around 65% to 235%. Only in 2006 and 2007 did the ratio decline.

Fig 8 Gross government debt, as a percentage of GDP

Source: IMF, Datastream, Macquarie Research, January 2016

Fig 9 Japan’s primary budget balance & Gross public debt as a % of GDP

Source: OECD, Macquarie Research, January 2016

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Financial repression


20 January 2016 7

Nonetheless, considerable progress has been made, and we believe that the growth in the

ratio of public debt to GDP will be sustainably arrested by the implementation of the next

consumption tax rate increase to 10% (ex food) from 8% scheduled for April 2017.

Consumption tax revenues are approximately ¥2.5tr for every 1%. This is equivalent to

approximately 0.5% of GDP. The increase in the consumption tax rate from 8% to 10% (ex

food) will eventually transfer around ¥3.5tr from the private sector to the public sector,

equivalent to around 0.7% of GDP (food is approximately 30% of consumption).

At this point, we expect the government’s policy priority to shift more convincingly to

monetary reflation, Fig 6.

Japan’s considerable progress over the last three years towards stabilizing its public debt to

GDP ratio can be illustrated by using the formula for the primary budget balance necessary

for stabilization:

(Bond yields minus nominal GDP growth) x (Public debt/GDP)

Three years ago Japan needed a primary budget surplus of 2% (1%-0% times 2).

Today, thanks to the consequences of financial recession, Japan only needs a primary

budget deficit of 3% (0.5%-2% times 2) to stabilize the public debt to GDP ratio.

The combination of the second consumption tax rate increase to 10% (ex food), and the

ongoing tax revenue increases arriving with modest nominal GDP growth (Fig 11, Fig 12, and

Fig 13, next page) will bring a 3% primary budget deficit sustainably into range.

The FY2016 (FY3/2017) draft budget compiled by MOF, December 2015, has the following

numbers for the general account primary balance: FY2014 ¥18.0tr, FY2015 ¥13.4tr and

FY2016 ¥10.8tr. Using a static ¥530tr for nominal GDP, the general account primary deficit

ratios to nominal GDP are 3.4%, 2.5% and 2.0%.

Reconciling this with the MOF forecasts for net JGB issuance (FY2014 ¥41.3tr, FY2015

¥36.9tr and FY2016 ¥34.4tr) often causes confusion. The primary balance excludes debt

service costs. In Japan, there is also JGB sinking fund provision (redemption of the national

debt). For FY2016 these items are ¥9.9tr and ¥13.7tr respectively, for a National debt service

total of ¥23.6tr.

Please also note that Japan’s estimated public sector assets are in line with its public sector

liabilities, Fig 10. This broad balance is similar to the situation in the US, Germany, France,

the UK, and Canada. From this perspective, Japan is not an outlier in the G7.

Fig 10 Government gross debt to total assets

Note: World Economic Outlook October 2014, page 107

Source: IMF, Macquarie Research, January 2016

We have no medium-term concerns on fiscal sustainability, but by delaying the increase in

the consumption tax rate from 8% to 10% from October 2015 to April 2017, Japan has very

limited its fiscal flexibility over 2016-17 to offset the impact of China’s slowdown.

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20 January 2016 8

Fig 11 General government tax revenue, by month and year

2011 ¥tr YoY% 2012 ¥tr YoY% 2013 ¥tr YoY% 2014 ¥tr YoY% 2015 ¥tr YoY%

January 3.2 -2.3 January 3.3 5.3 January 3.4 1.4 January 4.1 21.5 January 4.9 18.3 February 3.2 -0.5 February 3.4 4.8 February 3.5 5.1 February 3.6 1.3 February 4.3 19.4 March 2.0 -0.5 March 2.1 2.1 March 2.2 4.5 March 2.5 14.6 March 2.5 1.2 April 3.8 6.3 April 3.9 1.6 April 4.1 6.0 April 4.3 5.6 April 4.9 13.1 May 6.8 0.3 May 6.9 1.3 May 7.2 3.6 May 8.3 15.4 May 10.2 23.8 June 1.8 4.1 June 1.9 8.1 June 2.0 4.9 June 2.0 1.4 June 2.1 3.1 July 4.5 3.7 July 4.4 -0.4 July 4.7 5.1 July 5.5 18.0 July 6.4 15.6 August 3.4 5.3 August 3.5 1.1 August 3.6 4.5 August 3.8 4.4 August 4.2 10.9 September 2.5 4.0 September 2.4 -0.8 September 2.5 0.5 September 2.6 7.1 September 3.3 26.5 October 2.8 -3.9 October 2.8 1.6 October 2.9 2.4 October 3.3 13.2 October 3.5 8.5 November 5.8 4.5 November 6.0 2.4 November 6.1 1.4 November 6.9 14.1 November 7.5 8.4 December 2.6 3.1 December 2.6 -0.3 December 2.7 2.6 December 3.0 11.4 December

Total 42.3 2.1 43.2 2.0 44.7 3.5 49.8 11.6 Year to date 53.7 14.7

Nom. GDP growth -2.3 0.8 1.0 1.6 1.0E

Note: The above is the commonly presented schedule from the MOF. Please be aware that total government tax revenues (central, local, social security) are around ¥160tr

Source: Ministry of Finance, Macquarie Research, January 2016

Fig 12 General government tax revenues, tax source

2011 2012 YoY% 2013 YoY% 2014 YoY% 2015 YTD YoY%

Total tax revenue 42.3 43.2 2.0 44.7 3.5 49.8 11.6 53.7 14.7

Income based tax 22.6 23.1 2.1 24.2 4.6 27.6 13.9 27.0 3.2 Income Tax 13.3 13.6 2.0 14.5 6.3 16.3 12.5 16.5 9.9 (of which Withholding) 11.0 11.2 1.6 11.9 6.7 13.5 13.0 13.8 12.0 (of which Self Assessment ) 2.3 2.4 3.9 2.5 4.7 2.8 10.2 2.8 0.1 Corporation Tax 9.3 9.5 2.3 9.7 2.0 11.3 16.1 10.5 -5.8

Property based tax 2.3 2.6 12.9 2.6 1.1 2.8 9.1 2.6 0.5 Inheritance Tax 1.2 1.5 20.8 1.5 -1.1 1.8 19.3 1.7 2.6 Stamp Tax 1.0 1.1 3.3 1.1 4.3 1.1 -4.4 0.9 -2.9

Consumption based tax 17.1 17.1 0.3 17.6 2.4 19.1 8.9 23.8 33.9 Consumption Tax 10.2 10.2 0.6 10.6 3.3 12.1 15.1 17.5 53.3 Liquor Tax 1.4 1.3 -1.5 1.4 0.9 1.4 -0.8 1.2 -1.2 Tobacco Tax 1.0 1.0 0.0 1.0 -3.1 1.0 -2.8 0.9 -3.0 Gasoline Tax 2.6 2.6 -0.3 2.6 -1.4 2.5 -3.4 2.3 -1.7 LPG Tax 0.0 0.0 -4.0 0.0 -4.9 0.0 -5.4 0.0 -4.9 Aviation Fuel Tax 0.1 0.0 -10.5 0.1 6.3 0.1 -0.4 0.0 0.8 Petroleum Tax 0.5 0.5 6.5 0.6 7.6 0.6 7.3 0.6 0.7 Motor Vehicle Tax 0.4 0.4 -8.2 0.4 -6.2 0.4 -4.0 0.4 5.3 Customs Duties 0.9 0.9 3.3 1.0 12.7 1.1 6.4 1.0 2.1 Tonnage Duties 0.0 0.0 2.7 0.0 1.5 0.0 -1.5 0.0 1.3 Others 0.0 0.0 na 0.0 na 0.0 na 0.0 na

Note: The latest month is November

Source: MOF, January 2016

Fig 13 Corporation tax revenue, by month and year

2011 ¥tr YoY% 2012 ¥tr YoY% 2013 ¥tr YoY% 2014 ¥tr YoY% 2015 ¥tr YoY%

January 0.2 -4.4 January 0.2 -0.6 January 0.2 16.8 January 0.2 -11.2 January 0.2 7.2 February 0.9 19.2 February 0.8 -4.1 February 1.0 14.1 February 0.9 -3.1 February 0.9 2.4 March 0.2 -3.4 March 0.2 19.0 March 0.2 3.9 March 0.2 -9.1 March 0.2 6.1 April 0.4 32.3 April 0.3 -14.3 April 0.3 7.3 April 0.3 -4.0 April 0.3 -12.5 May 3.8 6.1 May 3.8 0.7 May 3.9 1.7 May 4.8 23.4 May 4.4 -7.3 June 0.2 40.0 June 0.2 5.6 June 0.1 -21.0 June 0.2 29.4 June 0.2 -11.7 July -0.1 31.0 July 0.0 -47.7 July 0.0 -61.6 July 0.1 NA July 0.0 NA August 0.5 15.5 August 0.5 4.4 August 0.5 11.9 August 0.5 -2.1 August 0.4 -14.7 September 0.2 17.6 September 0.2 14.0 September 0.2 -12.0 September 0.2 6.7 September 0.2 3.0 October 0.3 -13.9 October 0.4 14.0 October 0.3 -12.3 October 0.4 12.3 October 0.4 -3.6 November 2.7 7.0 November 2.8 4.9 November 2.8 -0.5 November 3.4 21.4 November 3.3 -2.5 December 0.2 28.0 December 0.2 -5.3 December 0.2 -1.2 December 0.2 -7.9 December

Total 9.3 8.3 9.5 2.3 9.7 2.0 11.3 16.1 Year to date 10.5 -5.8

Note: The above is from the commonly presented schedule from the MOF, Fig 10.

Source: Ministry of Finance, Macquarie Research, January 2016

After the 11.6% YoY increase in general government tax revenues in 2014, revenues have

risen another 14.7% YoY in 2015 (year to date, to November).


20 January 2016 9

The 5-year JGB CDS market: watching for a warning signal

The late 2014/early 2015 move up in the 5-year JGB CDS spread, Fig 14, was significant in

the context of the improvements seen over 2012 to October 2014.

Fig 14 Japan’s CDS spread on 5-year JGBs, start 2012 to latest


Fig 15 puts that move into longer historical context, and contrasts it with corporate bond risk

spreads. Given that the latter has remained broadly stable over the last year, we believe the

move in the 5-year JGB CDS spread late in 2014 was caused by international factors.

Fig 15 5-year JGB CDS spread (black line) & the iTraxx Japan Series 12 relating to corporate bonds (red line)


Greece and fiscal sustainability worries about Japan

The CDS spread rose fairly persistently from 2008 until the end of 2011, Fig 15 above.

The election of the urban worker orientated DPJ party in August 2009, which initially

appeared less committed to medium-term fiscal reconstruction, was one factor. The

reconstruction cost of the March 2011 Japan disasters was another factor.

However, the major factor, in our opinion, was the Euro crisis, which kicked off in October

2009 with the revelations of the under-reporting of the Greek fiscal deficit, and began to

subside in late 2011. ECB President Mario Draghi’s statement: “Within our mandate, the ECB

is ready to do whatever it takes to preserve the euro. And believe me, it will be enough," was

made on 26 July 2012.

0

20

40

60

80

100

120

140

160

180

01

/12

04/1

2

07

/12

10/1

2

01

/13

04

/13

07/1

3

10

/13

01/1

4

04

/14

07

/14

10/1

4

01

/15

04/1

5

07

/15

10

/15

01/1

6

JGB 5YR CDS spreads

0

100

200

300

400

500

600

10

/06

01

/07

04

/07

07

/07

10

/07

01

/08

04

/08

07

/08

10

/08

01

/09

04

/09

07

/09

10

/09

01

/10

04

/10

07

/10

10

/10

01

/11

04

/11

07

/11

10

/11

01

/12

04

/12

07

/12

10

/12

01

/13

04

/13

07

/13

10

/13

01

/14

04

/14

07

/14

10

/14

01

/15

04

/15

07

/15

10

/15

01

/16

iTraxx Japan Series 12 CDS spreads on JGBs(bps)

The Euro crisis

kicked off in

October 2009 with

the revelations of

under-reporting of

the Greek fiscal

deficit, and began to

subside in late 2011


20 January 2016 10

Confidence in fiscal reconstruction in Japan only arrived later, from November 2012, when

the DPJ-LDP-New Komeito legislated both an increase in the consumption tax rate from 5%

to 10% (in two stages, the first to 8% in April 2014), and a 2.5% reduction in pension benefits

(to be phased in in three stages starting October 2013).

We believe the primary driver of the late 2014/early 2015 rise in the 5-year JGB CDS spread

was a spill-over of the re-emergence of the Euro-crisis led by the public debt sustainability

crisis in Greece.

Supply and demand in the JGB market

We forecast that the BOJ’s open-ended ¥80tr JGB annual buying target will be more than two

times the amount of new JGB issuance resulting from the government’s fiscal deficit over the

coming years, Fig 16.

We still believe the BOJ’s QQE program will continue into 2019: 26 November 2013 PEC’s

strategy weekly: Thinking about a BOJ exit...in 2019, with the implications for JGB ownership

shown in the table below.

Fig 16 JGB holding by public institutions, historical numbers to 2013, Macquarie forecasts thereafter

¥tr 2010 2011 2012 2013 2014E 2015E 2016E 2017E 2018E

Total outstanding JGBs 728 756 783 829 867 903 937 970 1002

New JGB issue forecasts (*) 40 36 34 33 32

Central Bank 58.1 67.6 90.9 143.6 190 270 350 430 510 Banks for small businesses (Post Bank) 180.7 171.6 164.0 162.3 160 160 160 160 160 Public Financial Institutions 3.4 2.0 2.3 1.4 2 2 2 2 2 Non-financial corporations, public 1.4 1.5 0.9 0.9 1 1 1 1 1 General Government 77.0 72.4 68.4 71.0 65 63 61 59 57 Public Pension (GPIF) 74.5 70.1 66.2 68.6 60 52 49 46 43 KAMPO (estimated) 60 60.0 60.0 60.0 60 60 60 60 60

Sub-total: Public sector holdings of JGBs 455 445 453 508 538 608 668 758 833 JGBs held by public sector (%) 62.5 58.9 57.8 61.2 62.1 67.3 71.3 78.1 83.1

Nominal GDP 482.4 471.3 473.8 478.1 494.8 504.7 514.8 525.1 535.6 Private sector held /nominal GDP (%) 56.6 66.0 69.7 67.2 66.5 58.4 52.2 40.3 31.6 Public sector held/nominal GDP (%) 94.3 94.5 95.6 103.0 108.7 120.5 129.8 144.4 155.5 Total JGB outstanding/nominal GDP (%) 150.9 160.4 165.3 172.9 175.2 178.9 182.0 184.7 187.1

Notes: The ownership data on JGBs does not include treasury financing bills. There are only two assumptions that really matter: 1) The length and size of the BOJ QQE program, 2) The new JGB issue i.e. the fiscal deficit. Our nominal GDP estimates escalate at 2% a year. GPIF is now in net outflow mode so we have declining bond holdings in our forward forecasts. GPIF domestic bond holdings at end-September 2015 were ¥53tr. Generally, other forecasts are flat. (*) These numbers include bonds issued for the “redemption of the National Debt” for which a strong case can be made for netting out. The MOF estimate for FY3/17 for this item is ¥13.7tr

Source: Bank of Japan flow of funds report, Macquarie Research, January 2016

Please note that if the program is carried out, (there are implementation issues):

1) The BOJ will own more than 50% of the outstanding JGBs by 2018 (510/1002)

2) The public sector will own 83.1% of the outstanding JGBs by 2018 (red shading)

3) Private sector held JGBs/nominal GDP will be 31.6% in 2018 (grey shading, top line)

Whilst 2019 is still three years away, we do expect discussion on exit strategies to increase

as the US Federal Reserve moves further way from its QE programs.

BOJ monetary policy is the subject of the next section.

Confidence in fiscal

reconstruction in

Japan only arrived

later, from

November 2012,

when the DPJ-LDP-

New Komeito

legislated both an

increase in the

consumption tax

rate from 5% to 10%


20 January 2016 11

Radical monetary policy We believe the BOJ actions in April 2013 involved a radical regime shift. A summary of the

new policies is in the 5 June 2013 PEC’s strategy weekly: Japan’s monetary policy regime

shift.

The Friday 31 October 2014 BOJ Shock & Awe #2 announcements are summarized in Fig

17, and in full at: http://www.boj.or.jp/en/announcements/release_2014/k141031a.pdf

Fig 17 The 31 October 2014 BOJ announcements: Expansion of Quantitative and Qualitative monetary easing (QQE)

Vote

(1) Accelerating the pace of increase in the monetary base 5 to 4 The monetary base will increase at an annual pace of ¥80tr, (an addition of ¥10-20tr compared with the past). End 2014 projected monetary base is ¥275tr, 80/275 = +29%

(2) Increasing asset purchases, extending maturity of JGB purchases 5 to 4 (a) Amount of outstanding JGBs will increase at an annual rate of about ¥80tr (versus ¥50tr) (b) The average remaining maturity of the Bank’s JGB purchases will be extended to 7-10 years (versus around 7 years before)

(c) Equity ETFs purchases, annual rate to ¥3tr (from ¥1tr) (d) J-REITs purchases, annual rate to ¥90bn (from ¥30bn) (e) CP and corporate bonds held outstanding will remain at current levels

Note 1: “The Bank will continue with the QQE aiming to achieve the price stability target of 2% as long as it is necessary for maintaining that target in a stable manner” (versus 2 years)

Note 2: In both cases, the policy board members voting against the above expansion (Morimoto, Ishida, Sato and Kiuichi) wished to continue with existing policies

Source: BOJ, Macquarie Research, January 2016

The possibility that the BOJ has already over-committed

Despite our positive position on Japanese policy overall, we believe that the BOJ made two

serious mistakes in 2014.

The first mistake, in our opinion, was the effective dropping of forward guidance when the

BOJ did not provide guidance on its 2015 operational details by the end of 1Q 2014. For

more, please see the 11 March 2014 Monetary policy outlook: No 2015 operational details

announced yet.

The second mistake is potentially more serious. As the imported inflation element began to

fade in 2H 2014, and having not communicated its operational targets for 2015 and beyond,

the BOJ felt the need to reiterate its commitment to its target of 2% CPI on a sustained basis

by introducing more aggressive measures on 31 October 2014. The key announcements

were the upping of the JGB purchase program to an ¥80tr annual rate from ¥50tr, and an

extension from 7 years to 7-10 years in the bond portfolio average remaining maturity target.

Please see the 3 November 2014 BOJ shock & awe #2 for more.

BOJ Governor Kuroda spoke to Japan’s leading business federation Keidanren on 25

December 2014: Welcome to the ‘2 percent’ club available here:

http://www.boj.or.jp/en/announcements/press/koen_2014/data/ko141225a1.pdf

On the final slide, the bond portfolio average remaining maturity target is described as “+3

years”. We believe the BOJ is going to have execution problems, possibly within 2016, with

these new commitments.

An annual JGB buying program of ¥50tr could have been sustained for at least five years, as

it implied the need to only persuade existing bond holders to reduce their overall holdings by

the equivalent of ¥10tr each year (the fiscal deficit is generating an average of around ¥40tr of

new JGBs each year). In contrast, ¥80tr implies existing bond holders reducing their overall

holdings by ¥40tr each year. With most government bonds held by domestic institutions in

hold-to-maturity asset-liability matching programs, this will be a major challenge.

After the 31 October 2014 BOJ Shock & Awe #2 announcement, investors appear to believe

that Governor Kuroda will try anything, do whatever it takes, including a Shock & Awe #3 if

necessary. We disagree.

We believe the BOJ

is going to have

execution problems,

possibly within

2016, with these

new commitments

We believe that the

BOJ made two

serious mistakes

in 2014


20 January 2016 12

He was appointed by PM Abe of a LDP government backed by big business for a five-year

term ending 8 April 2018. We believe the financiers of the LDP party will prevent him from

undermining big business interests. For example, suggested additional BOJ policy options all

look unlikely, in our opinion:

1) Cut the 10bp paid on excess reserves (IOER, interest on excess reserves) and follow the

Swiss, Danes and Swedes into negative official deposit rates. We would expect the big banks

and Japan Post to strongly resist this. We regard this is an extreme option that would only be

considered if the Yen became very strong.

2) Flatten the yield curve further, driving 30-year rates to less than 1% (currently 1.3%). This

would be a policy similar to “Operation Twist” introduced by the US Fed in September 2011.

We would expect the insurance industry to strongly resist this as it undermines the viability of

new business, their ability to implement asset-liability matching risk management.

3) Attempt to buy other existing high-yield paper – these markets are small and mainly in

hold-to-maturity accounts.

4) Buying foreign-denominated assets – big business doesn’t want to risk protectionist wrath

in the US, and with Japan’s current account surplus surging back from barely positive to 2.5%

in 2015, on our estimates, we would also expect the US Treasury to object strongly.

5) Introduce a loan program with interest rates beneath 10bp so that banks are able to do the

equivalent of a carry trade, borrowing from the BOJ and depositing at the IOER. The BOJ

would be paying the private sector to expand the BOJ balance sheet. It is hard to imagine a

real economy impact from this option.

The 17-18 December 2015 “technical adjustments”

It is in the context of the foregoing that the following BOJ announcements underwhelmed

investors:

1) Extend the bond buying average remaining maturity to 7-12 years. We believe this

has been introduced to facilitate a reduced BOJ presence at the short end of the

curve, in the treasury bill market, where interest rates are negative.

2) Own “up to 10%” of any J-REIT (from “up to 5%”).

3) Possibly invest in equity ETFs tilted to companies proactive on capital expenditure

and human resource investment.

The realization by investors that the BOJ has largely reached its policy easing limits is, we

believe, a developing risk.

We believe that the risk needs to be split into two:

1) A realization that the BOJ’s QQE program is likely to persist until 2018-19, our house

view, gradually becomes the market consensus. We believe this would be supportive

of a multi-year TOPIX Bull market, driven by earnings.

2) A realization by investors that the BOJ will not undertake a Shock & Awe #3

announcement could lead to a possible establishment of a net long speculative

position in the Yen. Currently, traders have net flat positions, Fig 30.

Our house ¥/US$ forecast, table front cover, has the Yen beginning a mild trend appreciation.

BOJ messaging: Changing private sector behaviour remains a 3-5 year challenge

The BOJ has followed a policy of Shock & Awe. This is a very different approach to the way

the US Fed has been communicating with the markets.

However, whilst BOJ Shock & Awe #1, the 4 April 2013 BOJ regime shift, was unanimous,

the BOJ Shock & Awe #2 was carried with only a 5 to 4 vote. We struggle to imagine a

package that could be delivered as a BOJ Shock & Awe #3. In other words, it appears the

BOJ has already fired all its policy bullets.

We do not expect private sector behaviour to materially change over the next two years. The

consequences are visible in bond market yields, which remain subdued.

The realization that

the BOJ has largely

reached its policy

easing limits is a

developing risk

We believe this

would be supportive

of a multi-year

TOPIX Bull market,

driven by earnings


20 January 2016 13

The BOJ replaced its previous “1% price stability goal” with its new “2% price stability target”

in January 2013, and in April 2013 committed to achieve the 2% inflation target “over a time

horizon of about two years”. In addition, the BOJ has committed to maintain the policy for “as

long as is necessary for maintaining the target in a stable manner”.

This last sentence is, we believe, intended to assure the market that there will be no repeat of

2006. In 2006 the BOJ ended QE whilst both headline and core CPI were still negative. Core

inflation peaked in mid-2008 at just 0.4%.

The 31 October 2014 BOJ announcement eliminated the 2-year expectation: “The Bank will

continue with the QQE aiming to achieve the price stability target of 2% as long as it is

necessary for maintaining that target in a stable manner.”

The communication expectation as to when the 2% consumer price inflation target will be

reached has so far evolved as follows:

1) 2% within 2 years

2) 2% within around 2 years

3) Towards the latter half of the projection period

4) 2% in or around FY2015

5) 2% inflation at the earliest possible time with a time horizon of about 2 years –

Deputy Governor Nakaso, April, 2015

Deputy Governor Nakaso spoke on 27 July 2015, and he emphasized how it was now

necessary to look through the recent decline in oil prices. Some quotes follow.

The underlying trend in inflation, as I will explain later, has continued to be of improvement,

although the year-on-year rate of increase in the consumer price index (CPI) has declined,

due in particular to the effects of the substantial decline in crude oil prices since last summer,

and recently has been about 0 percent.

Some may wonder how the rate of increase in the CPI can really reach 2 percent around the

first half of fiscal 2016, given that the current level is about 0 percent. In response to this

question, it may help you understand if we decompose the changes in consumer prices into

two parts: the contribution of energy prices and the underlying trend in inflation.

In other words, as the negative contribution of energy prices dissipates, this alone will push

up the year-on-year rate of increase in the CPI for the first half of next fiscal year by about 1

percentage point, compared with that for this summer.

The chart below accompanied the speech.

Fig 18 Consumer prices

Note: Figures are estimated adjusted for the direct effects of the consumption tax rate hike in April 2014

Source: Ministry of Internal Affairs and Communications, Bank of Japan, Macquarie Research, January 2016

Subsequently, the BOJ has begun to popularize the CPI ex fresh foods and ex energy. Fig 19

shows this along with the CPI ex fresh foods, the latter being the official target measure. Fig

19 comes from Governor Kuroda’s 25 December 2015 “At the turning point” speech available

here: http://www.boj.or.jp/en/announcements/press/koen_2015/data/ko151224a1.pdf

It is now necessary

to look through the

recent decline in

oil prices


20 January 2016 14

Fig 19 Japanese consumer prices

Note: Figures are estimated adjusted for the direct effects of the consumption tax rate hike in April 2014. Figures for the CPI (all items less fresh food and energy) are calculated by the BOJ

Source: Ministry of Internal Affairs and Communications, Bank of Japan, Macquarie Research, January 2016

Persisting with the current policy until 2018-19

Double-entry accounting means that when JGBs are an asset they are backing an equal

liability. In the case of the central bank, the liability is current deposits of the banking system:

These deposits have the potential to be used as high-powered money which through the

credit multiplier would result in a credit boom, private sector demand for credit permitting.

The central bank could neutalise this through a variety of techniques such as demanding

higher reserve ratios. The negative outcome, however, will be a significant portion of banking

sector assets sitting at the BOJ generating a 10bp return on those deposits in excess of

required reserves.

Richard Koo in his latest book: The escape from balance sheet recession and the Q.E. trap is

much more negative than this author on the exit costs.

We are not expecting robust demand for loans by the private sector, but, rather, a

continuation of the 3-4% pa domestic lending growth of the last three years. This means

banks will have no choice but to maintain large excess reserves balances at the BOJ.

Please see the centre bottom text box in Fig 21: “Central bank”. The BOJ’s QQE program

(mainly JGB purchases) has increased the “Central Banks assets (securities)”, whilst the

corresponding liability is an increase in “Deposits with the Bank of Japan”. The latter is the

increased commercial bank deposits held at the BOJ, often referred to as the banking

system’s reserves held at the central bank.

The increase in the “Central Bank’s assets (securities)” has so far principally come directly

from the banking system, Fig 20, though, as Fig 21 notes, holders of JGBs are much more

diverse. Please follow the dotted line out of the “Central Bank assets (securities)” box.

Fig 20 JGBs held by city banks

Source: Bank of Japan, Macquarie Research, January 2016

0

20

40

60

80

100

120(¥tr)

JGBs held by city banks

The increase in

Central bank’s

assets (securities)

has principally

come directly from

the banking system


20 January 2016 15

Fig 21 Financial assets and liabilities by sector (end of March 2014) unit: ¥tr

Note: 1) Major sectors and transaction items are selected to show the overview of the flow of funds. 2) Loans and borrowings include “ Bank of Japan loans”, “Bills purchased and sold”, “Loans by private financial institutions”, “Loans by public financial institutions”, “Loans by the nonfinancial sector”, “Instalment credit”, and “Repurchase agreement and securities lending transactions”. 3) Securities include “Shares and other equities” and “Securities other than shares”. The latter consists of “Central government securities and FILP bonds”, “Bank debentures”, “Industrial securities”, “Investment trust beneficiary certificates”, “Trust beneficiary rights”, etc. (Securities in external claims of Japan is “Outward investment in securities”.) 4) the sum of the transaction items which are not shown individually is represented by ‘others’ in the above charts.

Source: BOJ Flow of Funds statistics, Macquarie Research, January 2016

Households (355) Households (1,645)

(including sole

proprietorships)

( Banks, Collectively managed trusts, etc. ) (including sole

proprietorships)

Others 52

(1,302)

Others 69

Loans 52

Others 275

Securities 281

General

government(1,177) Others 432

General

government(537)

Securities 224

Others 20 Others 276

Overseas (504) Overseas (826)

Borrowings 117

Others 99 Others 223

Depository corporations

Borrowings 302

Loans 688

Deposits 1,294

Currency and

deposits

874

Private

nonfinancial

corporations Securities 510

Securities 261

Borrowings 341

Securities 119 Insurance and

pension reserves441

Insurance and pension funds

Securities 687Insurance and

pension

reserves

441Securities 364

Private

nonfinancial

corporations

(943)

(Of which: shares

42

401)

Currency and

deposits229

Other financial intermediaries

Securities investment trusts, Nonbanks,

Central government, Fiscal Loan Fund, Government financial

Local governments, and

Social security funds

institutions, Financial dealers and brokers

Borrowings 163

Loans 451

Deposits with

the Fiscal

Loan Fund

Central government,

Local governments, and

Social security funds

Securities 994

Deposits with the

Fiscal Loan Fund37

Borrowings 222

Securities 263Central bank

Securities 486

Securities 118Securities 391

Loans 142

Securities 227

Deposits with

the Bank of

Japan

(External debts of Japan) (External claims of Japan)

152

Loans 30 Currency 91

Liabilities(fund raising) Assets(investments)Assets Liabilities

LiabilitiesAssets


20 January 2016 16

Assuming that the continuation of the BOJ QQE program delivers low nominal bond yields,

and negative real interest rates along the yield curve, Japan’s financial system as a whole will

face challenges generating the necessary running yield to meet the short-term obligations of

its liabilities, e.g. insurance policy pay-outs in the case of the insurance industry.

Running yield will remain scarce in Japan.

PM Abe’s three new feathers – another sign that policymakers are “all in” already

We believe PM Abe has already begun campaigning for the July 2016 Upper House

elections, as evidenced by an increasingly populist tone in his speeches, e.g. encouraging a

probe into telecommunication charges. In a speech in September 2015 he introduced three

new “arrows”, which, in our opinion, have little macroeconomic consequence.

1) Nominal GDP from ¥500tr to ¥600tr, with no time period specified

2) The fertility rate to 1.80 from the current 1.40, with the main policy support being

improved child care facilities, and access thereto

3) Elderly care, nursing facilities to be strengthened so that no-one needs to drop out of

the employment market to take care of elderly relatives

In addition, PM Abe has decided to introduce food exemptions from the next consumption tax

rate increase.

Of the three original policy arrows, monetary policy is fully deployed, in our opinion, flexible

fiscal policy is now committed to fiscal reconstruction and the second consumption tax rate

increase, and structural reform is on hold awaiting the US Congress ratification vote on the

TPP agreement. What has happened to monetary reflation?

Monetary reflation is expected to arrive at the latter end of a 2013-2019 seven-year program.

Fig.22 is our long-standing flow-chart.

Fig 22 From proactive monetary reflation to the end of entrenched deflationary expectations


Running yield will

become

increasingly scarce

in Japan

Weak Yen

Proactive monetary reflation

Improving net exports

Rising overtime income

Increased bonus

payments

End of entrenched deflationary expectations

Profits surge

Rising base

wages

Capex

Closure of output gap

Rising equity prices

Falling property cap

rates

Negative real interest rates

Flatter yield curve

Rising land prices

Positive nominal GDP

growth

Wealth effect

Stronger consumption

growth

Monetary reflation is

expected to arrive at

the latter end of a

2013-2019 seven-

year program

What has happened

to monetary

reflation?


20 January 2016 17

Leakages that are delaying the end of entrenched deflationary expectations include:

1) Companies only modestly cutting their US$ prices to the benefit of profit margins

(corporate revitalisation), but at the expense of export volume growth (boosting domestic

demand)

2) The consumption tax increases (fiscal reconstruction) impacting the “stronger consumption

growth” channel

3) Companies investing the “profit surge” principally overseas, slowing down the “closure of

the output gap”.

Monetary reflation and property

We believe the BOJ is seeking a long, sustainable property cycle, rather than the shorter,

more intense cycle of 2005-08.

The BOJ continues to acquire real estate assets via its J-REIT purchase program.

Please see Fig 23 and Fig 24 from the BOJ’s October 2015 Financial System Report.

Released in April and October each year, the Financial System Report monitors financial

stability. In Fig 23 red is “overheating”, whilst blue is “too cool”.

1987-90 has an abundance of red. In retrospect (these indicators were not in use then),

waiting until 1989 to increase policy interest rates was too slow. The period of tightening ran

from May 1989 until August 1990 with policy rates increasing 350bp.

The BOJ increased its policy rate by 25bp in August 2000. In Fig 23, 2000 was predominately

green, with three blue cells to zero red cells. The BOJ reversed the interest rate increase in

March 2001.

The BOJ 50bp tightening from July 2006 through until February 2007 is especially interesting

as it was accompanied by regulatory monitoring of real estate lending. Please note that the

latter was the only red cells during this period.

Fig 23 Heat Map of financial activity indicators (please see footnote 1)

Source: BOJ October 2015 Financial System Report, Macquarie Research, January 2016

Fig 24 on the next page shows the underlying series behind the real estate investment to

GDP ratio signal. As Fig 23 shows, the BOJ has recently been concerned about

developments here.

We believe the BOJ

is seeking a long,

sustainable property

cycle


20 January 2016 18

Fig 24 Real estate investment to GDP

Source: BOJ Octoberl 2015 Financial System Report, Macquarie Research, January 2016


20 January 2016 19

Structural reform: The TPP opportunity The first good news is that the PM Abe administration is primarily relying on the

private sector, the market, to effect change.

The TPP is about open trade in goods, shared rules in services, intellectual property rights,

and government procurement. It would bring modest gains from improved trade efficiencies,

but potentially major gains to capital efficiency and the TOPIX ROE, below.

Fig 25 TPP, improved trade efficiency, and the benefits of FDI inflows


Please see the 10 December 2014 PEC’s Japan strategy: Top of our 2015 Wish List: TPP for

a numerical estimation of the TPP opportunity. We believe trend potential real GDP growth

could be boosted by 0.2% per annum. Moving inward FDI flows from approximately zero to

0.5% of Japanese GDP over five years would add 0.1% pa. Efficiency gains from competition,

new business models and techniques, the elimination of sub-scale local companies could

provide the rest. The 10 December 2014 report concluded that the TOPIX ROE could rise by

2% as a result.

A sustainable ROE of 11% rather than 9% would boost the TOPIX fair value PBR by 0.4 (440

TOPIX points with TOPIX BV of 1,100), using the [ROE-g]/ [COE-g] framework from the 5

August 2015 PEC’s Japan strategy: Road testing TOPIX 1800.

Rather than greenfield investments, foreign companies could use aggressive takeovers and

accelerate the above gains. This was examined in two reports: 13 May 2015 PEC’s Japan

strategy: Japan’s M&A Boom inflates again & 27 May 2015 PEC’s Japan strategy: Is Japan

ready for US MNCs?

As explained in the 10 December 2014 report, we believe that the three main areas to look for

company-level potential TPP beneficiaries are:

1) Japan’s service sector MNCs

2) Agriculture and food processing

3) Japan’s health industry

Since we expect a US MNC to test Japanese market access, emboldened by the TPP,

another area to look for investment opportunities is:

4) Low ROE, large domestic franchises.

5) Fragmented domestic industries open to a foreign consolidator

Trade friction benefits

FDI inflowsBenefits from competition

New Business models and techniques

Up to 0.5% of GDP p.a.

[Text]

Relative to capex/GDP of

13%

Elimination of sub-scale local

companies

Improved capital

efficiency

Real GDP growth

0.2% pa

TPP would bring

modest gains from

improved trade

efficiencies, but

potentially major

gains to capital

efficiency and the

TOPIX ROE

The TOPIX ROE

could rise by 2%

A sustainable ROE

of 11% rather than

9% would boost the

TOPIX fair value

PBR by 0.4 (440

TOPIX points), using

the [ROE-g]/ [COE-

g] framework


20 January 2016 20

There is a marked divergence between big and small companies, with the (COGS +

SGA)/Sales ratio being higher for smaller companies across virtually every sector. We believe

that this reflects a well-known impediment to higher ROEs in Japan: the lack of exit of weak

companies. There is no active market in corporate control in the stock market. Banks do not

appear to build an adequate cost of credit premium into borrowing costs, leading to a low

level of bankruptcies.

Evidence for the above is to be found in Fig 26, which shows that Japan has a pronounced

productivity deficit in service sectors such as:

1) Transport and warehousing (45.7% of the US productivity level)

2) Wholesale and retail trade (42.9% of the US productivity level)

3) Food and accommodation (26.8% of the US productivity level)

The width of the columns is proportional to the 2003-07 average added value shares.

Investors need to watch for enabling reforms to the reallocation of resources in Japan:

1) The bankruptcy code, and the social stigma of banks forcing exit

2) Labour market flexibility, government assistance, portable pensions etc

Fig 26 Japan’s productivity in comparison with the USA (non-manufacturing sectors shaded in pale blue)

Note: Transportation equipment includes airplanes, ships and train cars. Comparing only companies in the automobile industry, the labour productivity level improves to 106.1 against the US level. The above is page 4 of the PowerPoint outline summary of the White Paper on International Economy and trade 2013, created based on “EU KLEMS”. It is available here: http://www.meti.go.jp/english/report/downloadfiles/2013WhitePaper/outline.pdf

Source: METI, Macquarie Research, January 2016

The lack of exit of

weak companies


20 January 2016 21

Fast Track, a TPP agreement, Ratification

PM Abe formally announced Japan’s intention to join the TPP on 15 March 2013. President

Obama signed the Fast Track bill on Monday 29 June 2015. A TPP agreement was reached

on 5 October 2015.

The agreement needs to be ratified by national governments. Its ratification by the US

Congress is a significant hurdle, and there is no visibility on the timing of the vote. The

agreement is available to be read here:

http://www.mfat.govt.nz/Treaties-and-International-Law/01-Treaties-for-which-NZ-is-

Depositary/0-Trans-Pacific-Partnership-Text.php

In the 3 April 2013 PEC’s Japan strategy: Japan’s road to structural reform we wrote:

“We believe the TOPIX ROE is heading into the 10-12% range. The two principal drivers

are: 1) the eradication of entrenched deflationary expectations, which underpin our cyclical

recovery TOPIX ROE forecast of 10% in FY3/15 [the actual was nearer 9%], 2) structural

reform, entry into the TPP and improved corporate behaviours which will drive the TOPIX

ROE sustainably into the 10-12% range. Building conviction in reform is a tricky issue.

The prospect for reform is best understood, we believe, by drawing parallels with the PM

Koizumi administration of 2001-07, and its major reform achievements: 1) the forcing of a

resolution to the bank NPL problem, 2) the privatisation of Japan Post. The book The

structural reforms of the Koizumi cabinet by Heizo Takenaka is recommended for a detailed

account of this period. Heizo Takenaka emphasises the importance of having a large-scale

“reform menu” with a center-pin reform (as in ten-pin bowling) that provides the public the

hope that once accomplished there will be a series of additional changes that quickly follow.

Just as the Japan Post privatisation was this center-pin reform back in 2001-07, so, we

believe, Japan’s TPP entry is the center-pin reform now.”

Fig 27 TPP-related reports

Date Over-arching reports Content

1 July 2015 PEC’s Japan strategy: Fast Track and the TPP US President signs the Fast Track Bill 29 June 2015 27 May 2015 PEC’s Japan strategy: Is Japan ready for US MNCs? Imagine Wal-Mart, Home Depot and FedEx expanding rapidly in Japan 10 December 2014 PEC’s Japan strategy: Top of our 2015 Wish List: TPP Credible structural reform and a quantification of the potential opportunity 3 April 2013 PEC’s Japan strategy: Japan’s road to structural reform Japan’s entry into TPP negotiations on 15 March 2013

Institutional convergence with the USA

7 January 2014 Japan and the USA: What now in Japanese politics? The legislative status of the reform agenda 8 November 2013 Japan and the USA: The drivers of inward FDI flows The importance of institutional factors, rather than tax rates 2 November 2013 Japan and the USA: TPP progress so far The key outstanding negotiation issues 9 July 2013 Japan and the USA: Invest in Japan Inward FDI prospects 4 June 2013 Japan and the USA: Monetizing knowledge R&D, industry-university collaboration, the knowledge trade 21 March 2013 Japan and the USA: Profiting from good management Managerial practices compared 5 March 2013 Japan and the USA: The TPP and healthcare issues TPP is open trade in goods, services, investment, skilled labour

4 February 2013 Japan and the USA: Tariff ridden exports & the TPP The reconvergence of Japan towards the USA


The 10 December 2014 PEC’s Japan strategy; Top of our 2015 Wish List: TPP is the

“executive summary” report of the Japan and the USA series of reports on Japan’s

institutional convergence with the USA.

The 1 July 2015 PEC’s Japan strategy: Fast Track and the TPP is the starting point we’d

recommend to investors.

Over the past two and a half years, we believe investors have lost faith in the structural

reform third arrow of “Abenomics”. We believe that corporate Japan, however, remains

committed to market access reform. We believe the Japanese big business backers of the

LDP see two opportunities:

1) Level player access into the USA, closing the gap with those nations which have

already concluded a bilateral FTA with the USA.

2) Market share expansion in Japan, as the mass of poorly profitable small domestic

firms has to choose between joining a domestic champion and being steam-rolled by

US MNC competition.

Building conviction

in reform is a tricky

issue

The political

commitment of PM

Abe and the

LDP party

Key dates

Ma

cq

ua

rie R

es

ea

rch

P

EC

’s J

ap

an s

trate

gy

20

Ja

nu

ary

20

16

2

2

Fig 28 Japan Real GDP growth contribution by principal components and YoY % growth

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015E 2016E 2017E 2018E 2019E

Contribution to change (ppt)

Private consumption 0.3 0.7 0.9 0.6 0.5 -0.5 -0.4 1.7 0.2 1.4 1.3 -0.8 -0.2 0.2 0.0 0.2 0.4

Private residential investment 0.0 0.1 0.0 0.0 -0.4 -0.2 -0.5 -0.1 0.1 0.1 0.3 -0.2 0.2 0.2 0.0 0.0 0.0

Private investment 0.6 0.5 0.8 0.6 0.7 -0.4 -2.1 0.0 0.5 0.5 0.1 0.5 0.2 0.3 0.2 0.0 0.2

Private stockbuilding 0.3 0.5 -0.3 -0.1 0.3 0.2 -1.6 0.9 -0.3 0.2 -0.4 0.2 -0.1 0.1 0.0 -0.1 0.1

Public consumption 0.3 0.3 0.1 0.0 0.2 0.0 0.4 0.4 0.2 0.3 0.4 0.1 0.1 0.0 0.0 0.0 0.0

Public investment -0.5 -0.4 -0.5 -0.2 -0.3 -0.3 0.3 0.0 -0.4 0.1 0.4 0.2 0.1 0.1 0.1 0.0 0.0

Exports (goods & services) 1.1 1.7 0.8 1.4 1.4 0.3 -4.3 3.1 -0.1 0.0 0.2 1.4 0.2 0.2 0.2 0.2 0.1

Imports (goods & services) -0.4 -0.8 -0.5 -0.6 -0.3 -0.1 2.8 -1.4 -0.8 -0.8 -0.5 -1.4 0.0 0.0 0.0 0.0 0.0

Net exports 0.7 0.8 0.3 0.8 1.1 0.2 -1.5 1.7 -0.9 -0.9 -0.3 0.0 0.2 0.2 0.2 0.2 0.1

Real GDP 1.7 2.4 1.3 1.7 2.2 -1.0 -5.5 4.7 -0.5 1.7 1.6 -0.1 0.5 1.1 0.5 0.3 0.8

YoY% 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015E 2016E 2017E 2018E 2019E

Private consumption 0.5 1.2 1.5 1.1 0.9 -0.9 -0.7 2.8 0.3 2.3 2.1 -1.3 -0.4 0.4 0.0 0.4 0.7

Residential construction -1.3 1.7 -0.9 0.6 -9.8 -6.6 -16.6 -4.5 5.1 3.2 8.8 -5.1 8.0 8.0 0.0 0.0 0.0

Private investment 4.9 3.5 5.7 4.0 4.9 -2.6 -14.3 0.3 4.1 3.7 0.4 3.9 1.5 2.2 1.5 0.0 1.5

Public consumption 1.9 1.5 0.8 0.0 1.1 -0.1 2.3 1.9 1.2 1.7 1.9 0.3 0.4 0.2 0.0 0.0 0.0

Public investment -8.6 -7.5 -10.1 -5.1 -5.9 -7.4 7.0 0.7 -8.2 2.7 8.0 3.8 2.0 2.0 2.3 0.0 0.0

Exports (goods & services) 9.5 14.0 6.2 9.9 8.7 1.4 -24.2 24.4 -0.4 -0.2 1.2 8.4 1.0 1.0 1.3 1.3 0.6

Imports (goods & services) 3.9 7.9 4.2 4.5 2.3 0.3 -15.7 11.1 5.9 5.3 3.1 7.4 0.0 0.0 0.0 0.0 0.0

Real GDP 1.7 2.4 1.3 1.7 2.2 -1.0 -5.5 4.7 -0.5 1.7 1.6 -0.1 0.5 1.1 0.5 0.3 0.8

¥ trillion/Quarterly data SAAR 2010 2011 2012 2013 2014 1Q

2014 2Q

2014 3Q

2014

4Q

2014 2015 1Q

2015 2Q

2015 3Q

2015E YoY

Private consumption 300.4 301.2 308.1 314.5 322.1 305.6 305.6 307.8 310.6 308.2 306.5 307.7 309.4 -0.4

Residential construction 12.3 13.0 13.4 14.5 15.5 13.9 13.0 12.9 13.8 13.1 13.4 13.7 14.9 8.0

Private investment 64.1 66.7 69.2 69.5 75.1 71.1 71.1 71.1 72.2 72.1 71.2 71.6 73.3 1.5

Public consumption 97.3 98.5 100.2 102.1 101.9 102.3 102.5 102.8 102.4 102.7 103.1 103.4 102.8 0.4

Public investment 21.6 19.8 20.3 21.9 22.4 22.6 23.0 23.0 22.8 21.5 22.2 21.8 23.3 2.0

Exports (goods & services) 82.4 82.1 82.0 83.2 88.8 88.8 90.2 93.1 90.2 94.6 90.6 93.0 91.1 1.0

Imports (goods & services) 65.3 69.2 72.8 75.1 83.1 78.8 79.7 80.8 80.6 81.9 79.7 81.1 80.6 0.0

Real GDP 512.4 510.0 519.0 527.4 535.0 525.5 522.7 524.2 527.0 529.0 528.3 529.7 529.6 0.5

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015E 2016E 2017E 2018E 2019E

Nominal GDP -0.1 1.0 0.0 0.6 1.2 -2.3 -6.0 2.4 -2.3 0.8 1.0 1.6 1.0 1.1 0.9 0.5 1.2

GDP deflator -1.7 -1.4 -1.3 -1.1 -0.9 -1.3 -0.5 -2.2 -1.9 -0.9 -0.6 1.7 0.5 0.0 0.4 0.2 0.4

Note: Macquarie forecasts. The pale red highlights, 2003-07, are the slow but steady PM Koizumi growth period. 2014 shares in real GDP: Private consumption, 59.0%, Private residential investment, 2.6%, Private non-residential investment, 13.7%, Public consumption, 19.4%, Public investment, 4.3%, exports 17.1% and imports (a negative) 15.3%. Please note that the combination of the contributions to overall real GDP growth of consumption and private residential investment in 2015 is 0.0% and 0.4% in 2016.

Source: CAO, Macquarie Research, January 2016


20 January 2016 23

The outlook for the Yen Forecasts for the Yen need to take into account that it is around the 2-standard deviation

oversold level, Fig 29. This is perilous and needs to be built into any risk/reward investment

calculation.

Fig 29 Japan’s real effective exchange rate (REER), 1980 to latest

Note: the Yen traded on the high side of its long-term averages over most of the 1990s. 15 years of mild deflation was evidence of the tightness of monetary policy over this period, inappropriately so in our opinion

Source: BIS, Macquarie Research, January 2016

Many investors are surprised by Fig 29 and the indication that the Yen is as competitive today

as it was in 1984-85 pre the Plaza Accord, and as competitive as it was in 2006-07 when the

Yen was the major funding currency of the carry trade, Fig 30.

Please note that the source of Fig 29 is the BIS. The Bank for International Settlements is

popularly known as the central banks’ central bank, and should be regarded, in our opinion,

as an independent, trustworthy data source.

There seems to some confusion on the current competitiveness of the Yen because in 2006-

07 the ¥/US$ was around 120. Adjusted for mild deflation over 2008-13 (six years) in Japan

and 2% trend inflation in the USA, 120 then is equivalent to 102 today (120 x 0.85, with 0.85

being the outcome of 6 years of a 2.5% inflation differential).

Fig 30 The speculative net short in the Yen has been reduced


Shortly after the April 2013 BOJ Shock & Awe #1 announcement, the ¥/US$ moved into the

¥95-100/US$ range. As shown in Fig 29, this established the REER of the Yen comfortably

beneath the one standard deviation line on the cheap side.

60

70

80

90

100

110

120

130

140

150(2010=100) Median: 97.8

St.Dev.: 15.4

Nov: 74.0

-200

-150

-100

-50

0

50

100

01

/00

01

/01

01

/02

01

/03

01

/04

01

/05

01

/06

01

/07

01

/08

01

/09

01

/10

01

/11

01

/12

01

/13

01

/14

01

/15

01

/16

(000s)Bloomberg CFTC CME Japanese Yen Net Non-Commercial Futures Positions

Forecasts for the

Yen need to take

into account that it

is around the 2-

standard deviation

oversold level

The Yen at the end

of January 2015 was

as competitive as it

was in 1984-85,

before the Plaza

Accord...

....and as

competitive as it

was in 2006-07

when the Yen was

the major funding

currency of the

carry trade


20 January 2016 24

The subsequent move down into the ¥100-105/US$ range over November 2013-January

2014, was principally driven, in our opinion, by macro traders, as evidenced by the sharp

increase in the speculative net short in the Yen over that period, Fig 30.

The next move in the ¥/US$ was triggered by the 31 October 2014 Shock & Awe #2

announcement by the BOJ, with the ¥/US$ moving into the ¥118-122/US$ range.

Fig 31 Central bank activism: central bank total assets to GDP

Note: BOE data is only available until September 2014

Source: CEIC, Macquarie Research, January 2016

We believe this is broadly as far as the Yen falls, with our forecasts, Fig 32, looking for the

Yen to appreciate modestly going forwards.

We believe it would be a major accomplishment of the BOJ’s QQE program if it is able to

sustain the Yen in REER terms beneath the one standard deviation line. This would be

consistent with the Yen appreciating back to the ¥105-110/US$ range, though this would

certainly complicate the BOJ’s attempts to create 2% CPI on a sustained basis.

Fig 32 Japan: 10-year JGB and ¥/US$ forecasts (per year end)

YoY (%) CY14A CY15E CY16E CY17E CY18E CY19E

Exchange rate (¥/$) 119.8 120.4 118 114 110 104

US 10-year bond yields 2.17 2.27 2.60 2.70 2.70 2.70

10-yr JGB yields 0.33 0.28 0.60 0.80 1.20 1.20

Source: CEIC, Macquarie Research, January 2016

Many investors ask, if the Yen is now so competitive, why Japan isn’t experiencing an export

boom. We believe there are two principal reasons: 1) slow global growth, and 2) the

behaviour of MNCs. We believe the latter reason is the more important.

Whilst an export orientated economy is likely to adjust export prices as the currency shifts, an

economy dominated by MNCs is subject to their decisions on appropriate production sites.

The latter introduces decision lags, and is subject to legacy decisions. It is our impression that

over the four years of Yen strength 2009-12, the decision was taken to absorb the initial two

years in operating margin compression, and then relocation out of Japan decisions were

implemented over 2011-13. Please note that even so, Japanese export volumes on an

absolute basis only fell fractionally over 2011 and 2012, -0.4% and -0.1% respectively.

The next chart looks at the US import price indices for Japan and Germany. US$ import

prices from Japan have fallen just 10% since late 2012 (the ¥/US$ has fallen 36%).

Nonetheless, Japan is establishing a relative price advantage versus Germany. Sub-indices

for the machinery and transportation equipment (auto) industries are tracking these overall

numbers. In addition, Japanese companies are accelerating their rate of overseas expansion

with gross FDI abroad increasing from 1.5% over 2006-10 to near 3% in 2013, Fig 34.

0

10

20

30

40

50

60

70Total asset,% of GDP

Bank of Japan Fed Reserve ECB BOE

Japanese export

volumes on an

absolute basis only

fell fractionally over

2011 and 2012

We believe this is

broadly as far as the

Yen falls


20 January 2016 25

Fig 33 US import price indices for Japan and Germany (2004 to latest)

Source: CEIC, BLS, Macquarie Research, January 2016

Japanese companies have been reinvesting the improved profitability overseas, rather than

expanding capacity at home.

Fig 34 Gross FDI abroad as a % of GDP, 1990 to latest

Note: In comparison, domestic private investment is 13% of GDP, at the replacement capex level. Recent overseas FDI divides approximately equally between Greenfield plants and M&A

Source: IMF, MOF, Macquarie Research, January 2016

Fig 35 Domestic manufacturing production capacity in Japan, 1987 to latest

Source: METI, Macquarie Research, January 2016

95

100

105

110

115

120

125

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

From Germany From Japan

(Dec 2003 = 100)

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

Gross FDI outflow as a % of GDP(%)

90

95

100

105

110

1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015

(CY 10=100)

Production capacity

FY 03-07 ave: 97.6High November 2008 at 102.0

Japanese

companies have

been reinvesting the

improved

profitability

overseas...

... rather than

expanding capacity

at home


20 January 2016 26

The strong yen over 2008-12 has led to shrinkage in Japan’s manufacturing productive

capacity, Fig 35. From the November 2008 high to the July 2014 low, Japan’s industrial base

contracted by 6.9%. The restructuring trend now appears to have completed.

Currencies are never just about one country. Fig.36 shows the Yen as the most competitive

of the major four currencies, with the RMB at the top, followed by the US$ and the Euro. A

high real effective exchange rate is part of the mechanism that induces a rebalancing from an

investment-led growth model to a consumption-led growth model in China.

Fig 36 BIS Real Effective Exchange Rates

Source: BIS, Macquarie Research, January 2016

Based on our house forecasts, which expect the Euro to reach parity with the US$ at the end

1Q 2016, the Yen is set to mildly appreciate versus the Euro over the coming years.

Fig 37 Yen-Euro, actual from 2004, Macquarie forecasts to 2021

Source: Factset, Macquarie Research, January 2016

60

70

80

90

100

110

120

130

140 China Japan US EU

(2010=100)

90

100

110

120

130

140

150

160

170

180

Yen-Euro

The Yen is set to

mildly appreciate

versus the Euro

through March 2016

The Yen as the most

competitive of the

major four

currencies, with the

RMB at the top,

followed by the US$

and the Euro


20 January 2016 27

The outlook for TOPIX earnings 1) Historical earnings - the just passed interim results season

Fig 38 presents the results, usually the end September term. The results were generally

good, with the percentage of companies revising full-year net profit guidance exceeding those

revising down (20.4% versus 12.0%).

Given that Japan has been in recessionary conditions over April-September 2015, growing

1H sales by 4.1% YoY and net profits by 17.8% YoY is very impressive (orange highlights).

There have been two important tailwinds.

Fig 38 The current results season, key data

Number of companies reported (*): 739 Sales OP RP NP

Full-year growth: company estimate (%) 5.1 12.1 7.2 12.8

Full-year growth: Toyo Keizai estimate (%) 3.0 16.1 11.0 15.6

Full-year growth: Consensus estimate (%) 6.1 21.2 13.1 19.8

% of companies revising up FY guidance 15.2 21.5 21.0 20.4

% of companies revising down FY guidance 21.4 11.8 11.1 12.0

1H as % of FY guidance 47.4 51.7 52.4 53.7

1H YoY growth (%) 4.1 22.3 15.9 17.8

% of companies beating guidance 58.0 76.1 74.7 74.8

Note: (*) market cap above ¥50bn, through Friday 13 November 2015. OP: Operating Profit, RP: Recurring Profit, NP: Net Profit

Source: Factset, Macquarie Research, January 2016

The first tailwind was from the weak Yen over the last year, below. Currency will be much

less of a tailwind in the second half of the fiscal year.

Fig 39 Average Yen-USD for the three months and six month periods ending as shown below

Three months to end: Six months to end:

2014 2015 2014 2015

June September December March June September September March September

102.1 104.0 114.3 119.2 121.3 122.1 103.0 116.6 121.7

YoY -15.8% -14.9% -15.3%


We believe that overseas subsidiaries are approximately 40% of sales and profits. Whilst the

movement in the Yen-USD broadly applies to China and the Chinese RMB, other Asian

countries and Europe have seen their currencies depreciate versus the US dollar. Looking at

sales, and making the assumption, that the above currency move applies to 25% of total

sales, rather than 40%, leads to a note of caution. 25% times 15% is 3.8%. This compares to

1H YoY sales growth of 4.1% (orange highlights).

Please also note that the percentage of companies revising full-year sales guidance down

exceeds those revising up (21.4% versus 15.2%).

The second tailwind comes from the cut in corporation tax rates. Fig 13 has the data. Over

the six months to September 2015 corporation tax revenues were ¥5.5tr versus ¥6.1tr in the

co

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