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Higher yields leading to bank, insurance outperformance over REITs The Japanese equity market correction managed to last just for one day after the US election. The insurance sector has been the best performer since the US election on the back of a steeper US Treasury curve and higher rates. Michael Hartnett observes “violent rotation out of deflation to inflation plays”, including a move from REITs to US banks. This should apply to Japan, where banks and insurance have underperformed REITs amid relentless fall of the long-term yield and introduction of negative interest rate by the Bo) (Chart 5). The domestic policy condition has changed, however, as the Bo) is now reluctant to cut rate as it pays greater attention to the health of the financial institution. The Bo) now intends to prevent the yield curve from flattening excessively. While higher foreign yields may not lift yen rates as the Bo) controls the 10-year sector, reflationary environment outside Japan at least reduces the risk of a deeper cut at home. Outperformance of Japanese equities at the time of UST bear steepening has historically been led by cyclicals, banks and insurance (Exhibit 2). David Gleeson is cautious about REITs, while Futoshi Sasaki is constructive on banks. The move can stretch further near-term. Exhibit 2: US Treasury curve (2510s) move and market performance (past 43 quarters simple average, %) - USD/JPY, Japan equity (local ccy term), and Japanese cyclical, bank, insurance tend to outperform at the time of UST bear-steepening Dollar MSCI MSscCl USDJPY index a Japan / Japan sector* (DXY) ex Japan* Discretion Financials Materials IT Industrials Energy Telecom Staples — Utilities Health ary care Bear steep 4.12 -0.60 8.58 3.32 11.68 9.97 9.96 9.46 8.58 5.88 3.27 2.86 2.83 1.89 Bear flat 1.90 0.31 3.88 0.58 3.49 -0.44 5.44 4.09 3.88 4.26 3.66 2.34 -0.06 5.21 Bull steep -1.85 0.35 -2.32 -2.76 -3.03 -2.44 -4.70 4.22 -2.32 -3.46 2.44 1.44 -3.64 -0.47 Bull flat -4.49 1.26 -7.31 -5.05 8.91 -11.10 -9.94 8.23 7.31 -9.61 -0.37 -1.50 -4.16 -1.59 Source: BofA Merrill Lynch Global Research, Bloomberg Used Bloomberg Treasury yield index. Curve movements defined based on 2yr move (up or down) and 2510s move (up or down) so these include twist movements, but even if we exclude these, implications for USDJPY and Japan equity do not change significantly. 11 quarters of bear steepening = average 16bps increase in 2yr yields and 33bps 2510s steepening; 10 quarters of bear flattening = average 26bps increase in 2yr yields and 20bps 2s10s flattening; 10 quarters of bull steepening = average 48bps decline in 2yr yields and 28bps 2510s steepening; 12 quarters of bull flattening = average 27bps decline in 2yr yields and 30bps 2510s flattening Japan / ex-Japan = MSCl Japan / MSCI Kokusai ratio Japanese sectors follow MSCI definition Chart 6: If inflation, rates surprise to upside, Japanese banks likely to outperform REITs 2.3 2.1 07 05 Nov-06 Nov-07 = Nov-08 Nov-09 Nov-10 = Nov-11 Nov-12 Nov-13. Nov-14.—-Nov-15——Nov-16 Bank/Reit Source: BofA Merrill Lynch Global Research, Bloomberg Bankof America 4 Japan Macro Watch | 14 November 2016 Merrill Lynch HOUSE_OVERSIGHT_014427