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Japan Investment Strategy
Nikkei to 20,000: Inventory cycle upturn →
cyclicals; inflation → banks, insurance

Bank of America
Merrill Lynch

Investment Strategy

18 November 2016

Bullish equities 2017; rotation into cyclicals, banks, insurance
We are bullish Japan equities for 2017 and we estimate the Nikkei 225 index will recover
to 20,000 by end-2017 (see $/'s eventual surge: Buy Nikkei 06 September 2016). Our
new Chief Japan Economist Izumi Devalier forecasts above-consensus Japan GDP growth
and inflation in 2017, which is also supportive of our bullish equities scenario (see Ready
for ignition 18 November 2016). We expect rotation into cyclicals, banks and insurance
as explained below.

1) Upturn in inventory cycle: Defensives→Cyclicals
We expect cyclicals to outperform defensives, premised on our end-2017 $/ estimate
of ¥120, and this is supported by our above-consensus economic growth outlook. Our
Japan economist sees a shift to fiscal easing, firms countering the tight labor market by
increasing capex, and estimates industrial production to grow 3.5% and 3.6% in 2017
and 2018, respectively. With the inventory cycle exiting a "contraction" phase and
entering a "recovery" phase, conditions are likely to remain conducive to cyclicals
outperforming defensives (Chart 1, Exhibit 3).

2) Higher inflation, rates: Deflation stocks→Inflation stocks
Up to 1H16, the Japan equity market saw continued preference for deflationary stocks
as domestic inflation remained subdued and the JGB curve underwent excessive bull
flattening. Defensives outperformed cyclicals (Chart 1), growth outperformed value
(Chart 2), and stocks that benefit from a low-yield environment (REITs) outperformed
the converse (banks, insurance; Chart 3). However, we expect conditions to reverse into
2017. We see US Treasury yields rising and Japanese core CPI inflation recovering to
+1.4% yoy by 2018 and core-core to +1.1% yoy. Stronger inflation and higher foreign
yields should steepen the JGB yield curve above10yr, while below 10yr should escape
from downward pressure as BoJ rate cut expectations recede. Against this backdrop, we
expect to see a rotation from deflation to inflation stocks, which in addition to cyclicals
means banks and insurance should outperform REITs within the financial sector (Chart 3).
This is also in line with the global rotation expected by Michael Hartnett (The Flow
Show: The Inflation Era Begins 10 November 2016).

3) Nikkei winner of steeper UST and strong macro
In a scenario of strong external demand and US rate hikes (particularly with curve
steepening), Japan equities tend to be the winner on a local currency basis, led by
cyclicals, banks and insurance stocks (Exhibit 4). Resurgence in the "Japan macro trade"
of short yen / buy equities is also a possibility.

Our Buy-rated stocks in bank, insurance and cyclical sectors are listed in Table 1.

Investment Strategy
Japan

Shusuke Yamada, CFA >>
FX/Equity Strategist
Merrill Lynch (Japan)
+81 3 6225 8515
shusuke.yamada@baml.com

Exhibit 1: Sector rotation and inventory
cycle

Slowdown
Inventory
Expansion
Defensives
June '12
8
6
June '15
Fundamentals
June '14
Production
4
2
0
-4
-2
0
2
4
6
8
10
Sep '16
-2
June '13
-4
Contraction
Cyclicals
Recovery

Source: BofA Merrill Lynch Global Research, Bloomberg,
Haver

Exhibit 2: Shares rated Buy by our
analysts in cyclical, bank and insurance
sectors*

Company
Ticker
Company
Ticker
Company
Ticker
Mitsubishi UFJ
8306 JP
Dai-ichi Life
8750 JP
JR East
9020 JP
FG
Japan Post
MS&AD
Bank
7182 JP
Holdings
8725 JP
JR Central
9022 JP
SMFG
8316 JP
Sompo
Holdings
8630 JP
Nintendo
7974 JP
Resona HD
8308 JP
Shin-Etsu
Chem
4063 JP
Recruit HD
6098 JP
Mitsubishi Elec
6503 JP
FUJIFILM
4901 JP
Oriental Land
4661 JP
Nidec
6594 JP
Sony
6758 JP
Fuji Heavy Ind
7270 JP
Hitachi
6501 JP
NTT DATA
9613 JP
Suzuki Motor
7269 JP
Panasonic
6752 JP
NSSMC
5401 JP

Source: BofA Merrill Lynch Global Research
*Market cap above 1.5trn JPY except bank, insurance
shares

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11687576

Timestamp: 17 November 2016 03:30PM EST

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