Banking stocks present opportunities in the Land of the Rising Sun

Dirk Jooste, co-fund manager of the PSG Stable Fund.

Japanese banks are currently attractive on both a price-to-book and price-earnings basis, says PSG Asset Management, despite Japan having endured a three-decade-long deflationary environment.

“Investors have been negative on Japan for some time because of its persistent economic challenges (including a high gross debt-to-GDP ratio) and demographic headwinds from an ageing population,” says Dirk Jooste, co-fund manager of the PSG Stable Fund. “They’ve been particularly negative on Japanese banks, which has created the potential for mispricing.”

In response to the deflationary backdrop, the Bank of Japan (BoJ) has kept short-term interest rates near zero – or even negative – since 1996.

In the most unprecedented monetary policy to date, the BoJ broadened its scope beyond short-term interest rates to controlling long-term interest rates as well (a policy implemented in 2016). Termed ‘yield-curve-control’, the BoJ has kept the 10-year government bond yield at around zero by offering ‘unlimited’ buying of long-term Japanese government bonds.

The current 10-year yield is just four basis points (0.04%), resulting in an entirely flat yield curve (very little difference between short- and long-term interest rates). Expectations are that rates will remain low indefinitely. “This has been immensely challenging for banks,” Jooste says.

Artificially low short-term interest rates have reduced banks’ primary source of income (their lending or net-interest margins). In addition, banks do better when short-term interest rates are lower than long-term interest rates, as the deposits on which they pay interest are normally shorter-dated than the loans on which they receive interest.

PSG has considered what lending margins – and hence profits – would look like in a normalised interest-rate environment, even if the timing of normalisation is very uncertain.

“Incorporating gradual normalisation into our ‘bull-case’ scenarios, our research shows that profits are likely to be substantially higher,” says Jooste.

Because Japanese banks are also currently attractive on both a price-to-book and price-earnings basis, despite the impact that narrow interest rate margins have had on earnings, PSG views any improvement in profitability from future interest rate normalisation as free upside optionality to its base investment case.

“On the other hand, the combination of low market ratings, low earnings and clean lending books means we see limited downside. This presents a very attractive investment opportunity with good odds for a positive outcome.”

In addition, economic and structural reforms should support future investment returns. Japan’s fiscal consolidation plans are taking shape: government revenues are rising despite multiple shocks over the past decade and expenditure has been kept stable. The economy is now growing at a healthy pace, and full employment bodes well for wages, consumption and inflation. Furthermore, the country’s debt net of assets paints a more accurate picture of its true debt position than its gross debt (an often-cited investor concern), as the Japanese government and the BoJ are very asset rich.

Business reforms are also encouraging, Jooste says.

While Japanese companies were once famous for life-long employment, this is changing. The major banks have substantial cost-reduction targets, often driven by increased automation and reduced headcount. Corporate governance and the focus on per-share value also appear to be improving. Despite Japanese companies having a long tradition of paying small nominal dividends, many are now increasing dividends and engaging in share buybacks. In an environment of static revenues, management actions to widen margins and return capital become a crucial component of shareholder returns.

The Japanese banking sector has spent the best part of the last two decades recovering from the effects of the asset bubble that burst in 1990. The industry has been substantially consolidated and recapitalised, and bank holdings in government bonds and stocks have steadily reduced.

“Japan has endured a number of storms over the past few decades, and while there is no way of telling when the sun will shine again, all storms eventually grow tired of blowing and seasons do change. While we don’t aim to predict the weather, we do take a long-term view and continue to apply our bottom-up approach regardless of market narratives,” Jooste concludes.