Risks: Geopolitics, diplomacy and US economic cycle
The biggest risk to our scenario is the implications for Japan’s diplomatic and geopolitical environment of the Donald Trump presidency in the US. The likelihood of agreement on the TPP (Trans-Pacific Partnership) has already declined and been priced into the market, but any downward spiral in Japan-US relations would likely be further negative for Japan equities near-term. A rise in protectionism would be negative for stocks with high US export exposure. Meanwhile if the US economy slows or enters recession and the protectionist response weakens USD, it would be negative for Japanese cyclicals, particularly exporters, due to stronger JPY and potential trade conflicts. Moreover, a potential improvement in US-Russia (US-China) relations under the new US President most likely implies a relative worsening in Japan-Russia (Japan- China) relations. On the other hand, we expect Japan to move closer to Europe under such a scenario, raising the incentive to sign the Japan-EU EPA (Economic Partner Agreement), positive for related stocks. If the Trump presidency tips the US towards isolationism, we expect Japan’s spending on defense to increase. If this results in higher spending on Japan’s Self Defense Forces (rather than compensating for US spending on Japan-based US military), Japan’s defense-related stocks would be beneficiaries, and it could reshape the arms industry in Japan.
Chart 1: Sector rotation and inventory cycle
130.0 40 125.0 4 120.0
115.0 20 110.0 ! I 40 100.0 iif rh Ine pet pol UT Lome 0 90.0 | /\
Defensive Defensive
85.0 ¥ |
80.0 Jan-09 Jan-11 Jan-13 Jan-15 memes Industrial production - inventory (3m mva yoy%) —— SCI Japan cyclical/defensive
Source: BofA Merrill Lynch Global Research, Bloomberg, Haver
Cyclical = Industrials, consumer discretionary, IT, materials
Defensive = Healthcare, telecom, consumer staples, utilities
Calculated cyclical and defensive % change using monthly index return and index weight
Chart 2: Japan — High Beta PB vs. Low Beta PB 2.0
High Beta PB / Low Beta PB
0.4 5
0.2
a 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17
Source: BofA Merrill Lynch Global Quantitative Strategy, MSCl, IBES Global Quant Panorama: Surf for longer 14 November 2016
BankofAmerica <2
2 Japan Investment Strategy | 18 November 2016 Merrill Lynch
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