Bank of America Merrill Lynch Japan Investment Strategy Report (Nov 2016)

Unauthorized redistribution of this report is prohibited. This report is intended for amanda.ens@baml.com Japan Investment Strategy Nikkei to 20,000: Inventory cycle upturn — cyclicals; inflation — banks, insurance Investment Strategy 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 abovelQyr, while below 10yr should escape from downward pressure as Bo) 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. >> Employed by a non-US affiliate of MLPF&S and is not registered/qualified as a research analyst under the FINRA rules. Refer to "Other Important Disclosures" for information on certain BofA Merrill Lynch entities that take responsibility for this report in particular jurisdictions. BofA Merrill Lynch does and seeks to do business with issuers covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. Refer to important disclosures on page 5 to 6. 11687576 Timestamp: 17 November 2016 03:30PM EST Bankof America Merrill Lynch 18 November 2016 Investment Strategy Japan Shusuke Yamada, CFA >> FX/Equity Strategist Merrill Lynch (apan) +81 3 6225 8515 shusuke.yamada@baml.com Exhibit 1: Sector rotation and inventory cycle Slowdown Inventory Expansion 8 Defensives = ee June "12 faite fea See | June ‘15 k ‘| Phe Fundamentals 2 ow June ‘14. i . axGt Beg Prod action 2 4 6 8 10 Contraction Recovery Cyclicals Source: BofA Merrill Lynch Global Research, Bloomberg, Haver Exhibit 2: Shares rated Buy by our analysts in cyclical, bank and insurance sectors* Company i Ticker Company Ticker Company Ticker Mitsubishi UFJ FG Japan Post MS8AD 7182.JP 8725JP | JRCental | 9022JP Bank Holdings Sompo SMFG 8316 JP 8630 JP Nintendo | 7974JP Holdings ResonaHo = ezoeJp | S™*ESY | anes up | Recruit | 6008 JP Chem Mitsubishi Elec: 6503JP | FUJIFLM | 4901JP | Onentalland | 4661 JP Nidec 6594 JP Sony 6758 JP_| Fuji Heavy Ind} 7270 JP Hitachi 6501JP | NTTDATA | 9613JP | Suzuki Motor | 7269 JP Panasonic : 6752 JP NSSMC 5401 JP 8306 JP. Dai-ichi Life 8750 JP JR East 9020 JP Source: BofA Merrill Lynch Global Research *Market cap above 1.5trn JPY except bank, insurance shares HOUSE_OVERSIGHT_014404