Japan Investment Strategy Nikkei to 20,000: Inventory cycle upturn → cyclicals; inflation → banks, insurance Investment Strategy 18 November 2016 Unauthorized redistribution of this report is prohibited. This report is intended for [email protected] 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. Stro