Japan

Japan is in a liquidity trap: bad economic news is good for the yen while good economic news is bad for the yen. Chinese reflation could help risk assets in the months ahead, but poor EM fundamentals will reassert themselves later this year. The yen bull market is not over yet. The BoC was more positive on growth than anticipated. The BoE's Super Thursday was a non-event.

A stronger yen is hampering efforts to revive the Japanese economy and the BoJ's failed NIRP experiment leaves open the option of direct currency intervention. Probability is also high that the April 2017 sales tax hike will be postponed, perhaps indefinitely. A major stimulus package, "helicopter drops" of money, and a 4% inflation target may be the only way to permanently overcome deflation. Near-term, further yen strength is likely, but the long-term path is down.

Clients should forgive us for being too gloomy at the start of the year -- it is difficult to be optimistic in the dead of a Montreal winter. However, with springtime comes the reflation trade, born on the wings of massive Chinese fiscal and credit expansion. In this report, we discuss how long (not very) the trade can go (and how to play it). Our In Focus feature returns to pessimism, with a discussion of why the Anglo-Saxon laissez-faire economic model may be in for a big pendulum swing.

Special Report

In this piece, we present our general analytical framework, with a focus on long-term determinants. We go through various methodologies and relate those methods to our views and current FX market developments, concluding that the dollar bull market is not over, EM currencies have more structural downside, and that it will take herculean efforts from the BoJ to arrest the yen surge.

The ultimate driver of bank profitability is loan growth. A brighter economic backdrop in the U.S. compared with both the euro area and Japan paints a rosier picture for relative credit growth opportunities (third panel). Already, bank credit growth in the U.S. is outpacing Japan and the euro area (top panel). This divergence has staying power, given that the U.S. economic expansion is becoming self-reinforcing, while the export-dependent euro area and Japan remain fragile. While loan volume generation is a key profit center for banks, loan pricing is equally important. On this front, negative interest rate policy (NIRP) in both the euro area and Japan are worrisome. NIRP puts an interest rate floor on deposit taking institutions that are reluctant to pass negative deposit rates onto their customers. Concurrently, NIRP forces banks to lend out new money, or roll over existing loans, at declining interest rates. This is especially constraining in the euro area periphery where mortgage lending is financed at the very short-end of the curve. The end result is a net interest margin squeeze (bottom panel). Meanwhile, each country is in a different phase of its credit cycle. U.S. and Japanese NPLs are probing multi-year lows, whereas euro area NPLs are very elevated (second panel). Tight labor markets in both the U.S. and Japan argue for a continuation of the downtrend in NPLs, although the rise in corporate bond spreads suggests that business loans are more at risk. The euro area's double-digit unemployment rate warns that NPLs will sap European bank profitability for a while longer. Bottom Line: U.S. financials are the best of a bad lot, while euro area and Japanese financials will continue to struggle to keep pace with broad market returns. For additional information on global financials please refer to the March 18 Global Alpha Sector Strategy report titled "Happy Days?".

Bank stocks comprise the bulk of financials indexes' market cap weights in the G3 (U.S., Euro Area and Japan). Thus, bank profit growth should largely define each region's financials sector earnings path, and by extension, relative performance. The top panel of the chart shows that the euro area and Japan have massive banking sectors as a percentage of GDP, especially compared with the U.S. Bank deleveraging is ongoing in the euro area, as banks continue to retrench from emerging markets and because of domestic economic slack. Sustained asset shedding in Europe is inherently negative for bank profitability, at least in the near-term, as bankers simultaneously become more conservative and reluctant to extend credit. Moreover, bank leverage ratios are stretched in Japan and in the euro area versus the U.S. (second panel). In other words, the equity capital cushion remains insufficient in the euro area and in Japan to absorb a local or global credit shock. U.S. banks are well capitalized following the Great Recession TARP recapitalization, but euro area banks continue to be plagued by ongoing and extremely dilutive equity capital raisings. Worrisomely, despite sporting higher leverage ratios, both Japanese and euro area financials ROEs trail the U.S. by a wide and rising margin (bottom panel). Steeply diverging regional ROEs should continue to drive a relative rerating of U.S. financials versus both euro area and Japanese financials (see the bottom panel of the previous Insight). Meanwhile, diverging credit and economic growth profiles, NIMs and NPLs, all favor U.S. versus both European and Japanese financials (please see the next Insight).

While relative financials stock returns tend to be highly correlated across regions, especially in the developed world (top panel), extremely divergent monetary policy developments and operating metrics suggest that these long-standing tight correlations are destined to loosen. Thus, Global Alpha Sector Strategy has broken down global financials sector coverage into three geographies: U.S., Europe and Japan, following in the footsteps of our recent disentangling of global consumer discretionary coverage (see the March 17 Insights). In that light, the euro area and Japanese financials sectors are at a particularly acute disadvantage relative to the U.S., given diverging leverage, capital cushions and ROEs (please see the next Insight).

We continue to recommend a cautious investment stance, staying at benchmark duration, as the recovery in risk assets looks more like a counter-trend rally than the start of a new bullish run.

We are sending you the Q2 <i>Global Investment Strategy Outlook</i>, which discusses the ten predictions we expect to drive global financial markets throughout the rest of the year.

Fed dovishness is weakening the U.S. dollar. As the ECB and BoJ move to the sidelines and the Fed remains reluctant to hike rates, the euro and Japanese yen should continue to recover versus the greenback.