Abenomics has taken the investment world by storm. While Abenomics, and particularly BoJ chief Kuroda's conventional central bank policy "blasphemy" makes investors nervous, this hasn't hindered Japanese equity performance from trashing essentially any other equity market or asset class year-to-date.
|Hat Tip: Business Insider|
Japan’s three megabanks, however, have significantly lagged this surge, as investors first piled into reflation stories like real estate (including “hidden” real estate assets) and later the big exporters as the substantial weaker yen windfalls began showing up in earnings and company forecasts.
In USD terms, Mitsubishi UFJ FG's ADR is performing somewhere between best-of-class JP Morgan (JPM) and 2008 financial crisis basket case Citigroup (C).
Japan’s Three Megabanks are Cheap, But..
Japan’s major banks largely dodged the US housing debacle, and have relatively strong balance sheets while profits in FY2012 were apparently good. Yet they are still selling below book value and well below market P/E multiples. Does this mean Japan bank stocks are due to catch up to soaring market benchmarks?
In FY2012, the big three logged strong results due to brisk earnings from overseas operations that, together with income from market products, more than offset slumping domestic lending services. But despite relatively strong balance sheet health, they have yet to improve their profitability. Interest margins last fiscal year were unexpectedly low because they chose to play it safe by extending loans to Japanese companies and blue-chip local firms. They provided virtually no funds to local venture businesses, where the profit margins are high.
The megabanks also remained weak in commissions-based businesses that help stabilize earnings without draining capital, while this is changing because of Abenomics. Sales of equity and real estate investment trusts risen since Abe's government took power in December have soared. For fiscal 2012, combined sales reached JPY5.4 trillion, up 20% YoY. Three out of five lender groups, including Mizuho Financial Group Inc., posted record-high annual group sales of investment trusts.
To offset a domestic lending margin squeeze that is being exacerbated by massive BoJ quantitative easing, Japan’s banking majors are for example hiring Spanish-speaking bankers to win new business in Latin America and giving loans to junk-grade borrowers in the United States to offset meager returns at home. They are also looking to increase lending denominated in local currencies, instead of the usual dollar-dominated loans.
Kuroda’s No Holds Barred Monetary Policy is Squeezing Bank Profits
While there are signs of recovery in loan demand from domestic companies, but the profits earned by the banks on their loan portfolios will fall if interest rates keep falling.
The three megabanks led by Sumitomo Mitsui Financial Group (8316) forecast earnings will decline 27% to JPY580 billion this year as monetary easing makes loans less profitable even as borrowing picks up amid an economic recovery. Mitsubishi UFJ Financial Group (8306)’s if forecasting an 11% decline to JPY760 billion yen and Mizuho Financial Group (8411)’s also expects an 11% drop to 500 billion yen.
Black Swan Risk Discount
Further, there is one big black swan risk that investors cannot ignore. The massive volatility in the JGB market could punch a big hole in still substantial bank holdings of government debt. Virtually all of Japan’s banks have been earning healthy profits by purchasing JGBs, but these profits are now at risk.
Banks’ large and increasing holdings of JGBs are a key source of vulnerability. With outstanding JGB holdings in Japanese banks (excluding Japan Post Bank) more than 30% commercial bank assets in Japan, the IMF warned in August 2012 that “JGB market exposures represent one of the central macro-financial risk factors”, where a 100bps (1% point) back-up in bond yields means 10% and 20% mark-to-market losses for regional and major banks respectively, which the current JGB move is rapidly approaching. In other words, a 100bps interest rate shock in the JGB yield curve would cause a JPY10 trillion loss for Japan's banks, according to JP Morgan estimates. Regional and Shinkin banks are smaller than major banks, but they together hold a large JPY50 trillion of JGBs versus JPY120tr of JGB holdings for major banks. If Kuroda does deliver on his 2% inflation target, Japan's banks stand to lose some JPY20 trillion on their government bond holdings as JGB yields rise to the sustainable inflation rate.
|Hat Tip: Zero Hedge|
Further, in terms of sensitivity to JGB interest rate shocks, Japanese banks appear to be more vulnerable than they were in 2003, when a sudden reversal in 10yr JGB yields from 0.5% in June 2003 to 1.6% was caused by banks scrambling to control their value at risk (VAR). Then, the bond selloff was aided and abetted by a rise in Japanese stocks, as investors piled out of one market and into the other, similar to conditions today. Now, a 100bps adverse move in JGBs would cause a loss of JPY3 trillion loss for major banks, but a JPY5 trillion loss for regional banks and JPY2 trillion loss for Shinkin banks, or a hit to Tier 1 capital of some 35% for regional and shikin banks versus only 10% for the major banks. The hit this time will be larger than in 2003, where the expected theoretical loss from a 100bps rate shock was around JPY2 trillion for major banks, JPY3 trillion for regional banks and JPY1 trillion for Shinkin banks, or significantly lower than estimated currently.
As the shorter-term chart below shows, the direction of JGB yields has clearly reversed. But does this mean a) the BoJ has already lost control of bond yields BEFORE they really get started in their shock and awe easing campaign, b) this is the beginning of the long-awaited (by the Japan bears), JGB crash?
The long-term chart of 10yr and 5yr JGB yields puts this short-term move into perspective. In our humble opinion, people are making a bit of a mountain out of a mole hill. Firstly, the high volatility and sharp short-term backup in yields comes after an historical drop-off in bond yields that represented the final leg of a two-decade implosion of JGB yields from over 8%.
During this period, bond yields have periodically punched lower, followed by a sharp "dead cat bounce" as overly bullish bond trading positions were covered. Similar snap-backs can be seen in 1994, 1999 and 2003. 1994/1995 was the first dramatic break-up in JPY/USD to below JPY80/USD, The 1999 bounce came amidst the second round of bank capital injections and negative growth in 1998, prompting the BoJ to introduce its ZIRP (zero interest rate policy) for the first time. While a VAR "shock" was the ostensible reason for the sharp reversal in JGB yields in 2003, the bounce came as investors realized Japan's banking and bad debt crisis was ending and stock prices began to soar. But for all of the excitement about Junichiro Koizumi's bank clean-up and "no growth without reforms" recovery (i.e., talk of "Japan is back"), bond yields never breached 2% as the basic deflationary factors were never completely eradicated.
In light of this 20-year history--including the 2003 VAR shock--the recent move in yields from a longer-term perspective is but a tempest in a tea pot, bank balance sheet sensitivity notwithstanding.
Thus while bank stocks are lagging in (rightly) allowing for black swan tail risk in their substantial JGB holdings, JGB yields themselves are far from spiraling out of the BoJ's control.
|Source: JPM, Hat Tip: FT Alphaville|
Bottom line, we expect this "black swan" discount as well as the squeeze on bank loan spreads from an aggressive BoJ to continue hobbling a more significant relative move in Japanese bank stocks. On the other hand, the strong "tide lifts all boats" momentum of underweight foreign pensions and renewedly bullish domestic and foreign fund investors should also keep the bank stocks bouyant if not outperforming the Nikkei 225.