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Japan, UK banking and the Federal Reserve

17 March 2017

Should I be considering Japanese equities?

Japanese equities have performed strongly since the falls that were triggered by the introduction of negative interest rates “NIRP” in Q1 2016. While the Bank of Japan has maintained negative rates, it moved to manage long-dated bond yields higher with ‘Yield Curve Control’ from September 2016. This curve management should help both insurance companies’ and banks’ profitability which is part of the reason why the financial sector has rallied so strongly. There is also a correlation to the US reflation assumption. We do not think that valuations look overly demanding despite the strong rally, especially when compared on a forward basis to other developed markets. However, the equity market has been highly correlated with currency moves rising on Yen weakness and in the recent past it has been prudent to hold Japanese equities on a currency hedged basis. Going forward, if Prime Minister Abe’s ‘Abenomics’ are successful then this relationship may finally be broken but we remain cautious given the interest rate differential that is expected to emerge with the US in 2017.

’Abenomics’ has three “arrows”: the first two, monetary and fiscal policy, have been in place for some time but the third arrow of structural reform has been harder to implement. This third arrow has many parts, but for the equity market the changes in corporate governance have been important with a greater emphasis on quality, return on equity and shareholder returns (dividends). Thus far Abenomics has clearly failed in the initial targets of sustained 2% inflation, but the recent monetary initiatives have been supportive of equities.

In summary - given the rally that has taken place since July 2016, we are not rushing to add Japanese equity exposure but may well look for an entry point further down the road.

What do you think of the UK banking sector? Clearly the banks are well capitalised, compared to their global peers and prior to 2008, but do you see a compelling investment opportunity with such low relative valuations?

The capital backing of the banks has indeed improved, and sector valuations do remain low relative to the UK market as a whole, but we remain selective. In the context of banks with large overseas operations, HSBC is preferred to Standard Chartered. We remain constructive on the prospect for capital returns, but are looking for a stronger operational performance before we increase our recommended weighting. Among the more domestic counters we prefer Lloyds, we have been impressed by their stable margins and falling cost to income ratio. Brexit presents some risks to the UK economy of course, but we believe that the scene is set for higher dividends, and a yield based re-rating.

Should we be concerned about the Bank of England raising rates?

The Federal Reserve moved rates up but, if anything, they were less hawkish than the market expected. By way of contrast, the Bank of England (BoE) left rates unchanged yesterday but appears marginally more hawkish than expected with one member of the Monetary Policy Committee (MPC) voting for a rate rise. Some people have argued that the rate cut following Brexit was not needed and they could take this back. Our view is that that with Brexit negotiations yet to start and the uncertainty around this, it is too early to raise rates yet. Inflation may go above the BoE target of 2% for CPI in the coming months but this is largely on the back of oil prices and sterling devaluation.

The futures market implied probability for a rise this year is now 36% up from 23% yesterday and 10 year gilt yields are up 0.04% on the day. This has supported sterling which was up 0.5% on the day. Equities were higher before the meeting and came off their highs after the announcement but the FTSE 100 was still up 0.6% on the day. Overall this is a fairly muted response. The MPC has had dissenting voters for long periods in the past without changing rates and Kristin Forbes who voted to raise rates is due to end her term on the MPC at the end of June.

We believe the Bank will continue to err on the side of caution and not raise rates this year.


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