Japan rates, Japan banks: “Let the good times roll”

Key Takeaways

• Interest rate hike: The Bank of Japan raised its policy interest rate by 25 basis points to 1.00% and plans to gradually reduce its monthly government bond purchases through 2027.
• Higher profitability projected: Higher interest rates are expected to boost the Return-on-Equity (ROE) of leading Japanese banks to 14%–15%, which is higher than current market consensus forecasts.
• Undervalued valuation upside: Because bank valuation ratios (P/B) strongly tie to profitability (ROE), rising interest rates create a meaningful upside for bank stock valuations that is not yet fully counted in market forecasts.

Bank of Japan interest rate decision

As anticipated, the Bank of Japan (BoJ) announced a 0.25% increase in the policy rate, raising it to 1.00% from 0.75%. With respect to its long-term JGB purchasing programme, the Bank stated that it will, in principle, continue reducing its monthly purchases by approximately ¥200 billion each quarter through March 2027, before shifting to purchases of around ¥2 trillion per month from April 2027.

Regarding the long-term neutral rate, as we have indicated on several occasions, we believe the BoJ is likely to revise its expectations upward from 1.5% to a range of 1.5%–1.75%. For reference, the deposit interest beta is approximately 0.4.

Rates, return-on-equity and Price-to-Book-ratio

There is typically a strong correlation between the Price-to-Book ratio (P/B) and Return-on-Equity (ROE) in the banking sector; accordingly, a rise in ROE should, in theory, support higher equity valuations. A theoretical PBR simulation based on ROE and the cost of capital is set out below.

Theoretical P/B simulation based on ROE and cost of capital

Source: Mizuho Securities Equity Research

Mizuho regresses the sector’s cost of capital of approximately 8%. This figure is derived from a sector P/B versus ROE regression analysis which, with an R² of 0.95, demonstrates strong explanatory power and currently implies a cost of capital of 8% for Japanese banks.

As a rule of thumb, at a policy rate of 1.00%, leading banks’ ROE is approximately 12%–13%; at 1.25%, approximately 13%–14%; and at 1.50%, approximately 14%–15%. These figures are not reflected in current consensus forecasts which stand at c.12.0%.

These ROE figures exclude any positive contribution from continued robust loan growth, Net-Interest-Margin (NIM) expansion, low credit costs, and share buy-backs, particularly their effect on the equity base. Accordingly, there is meaningful upside to these estimates.

For illustration purposes, we have chosen Sumitomo Mitsui Financial Group (SMFG) to demonstrate the ROE versus P/B relationship as well as earnings power in a historic context, applying sector theoretical P/B at 1.5%neutral policy rate as a reference point. One could also use the other two large city banks Mitsubishi UFJ Financial Group (MUFG) or Mizuho Financial Group.

SMFG – 24 months forward P/B and ROE

Source: Bloomberg

The charts above and below serve as a reminder of valuation and ROE levels prior to “Abenomics” (from December 2012) and the “Kurodanomics” (from March 2013). In our view, many market participants have limited experience of that environment and may therefore underestimate both the earnings potential and the corresponding valuation range that could re-emerge.

SMFG – 24 months forward net profits

Source: Bloomberg

Given the already strong earnings base and power—now significantly above the peak levels recorded in 2006 – and the fact that the prospective tailwinds from further BoJ rate increases, loan growth, NIM expansion, NII and share buy-backs are not yet fully reflected. Even an ROE of 15% and a valuation of 1.9x P/B appear conservative.

We will host SMFG CEO Nakashima at our office on 14th July. For reference, we will also host Mizuho Financial Group CEO Kihara on 7th July. These meetings should provide valuable insight into current trends and developments, particularly with respect to loan growth, NIM, NII, credit costs, and fee income.

JGB portfolio and duration

With regard to concerns over the potential negative impact of the banking sector’s JGB exposure, Japanese banks – aside from a limited number of regional exceptions – carry relatively low duration risk. JGB Bond portfolio duration stands at 0.9 years at Mizuho Financial Group, 1.5 years for MUFG and 3.9 years for SMFG.  In addition, the majority of securities classified as held to maturity are not subject to mark-to-market accounting.

Near-term catalysts

We maintain our constructive view on the banking sector in general, for the following reasons:

1. Expectations of solid net profit growth, driven primarily by low credit costs, higher fee income, and growth in domestic net interest income on loans and deposits in 1Q FY3/27
2. The prospect of upward revisions to FY3/27 guidance and additional shareholder return announcements during the 2Q FY3/27 earnings season
3. The likelihood of further BoJ rate increases and continued consolidation among regional banks

Summary

In our view, the broader backdrop remains favourable, and the runway for the sector is likely to extend for at least a further two to three years. Any near-term weakness should, in our opinion, be viewed as an opportunity given the increasingly visible path towards a policy rate of 1.5%–1.75%.

Glossary

Policy rate: The benchmark interest rate set by a central bank to influence economic activity and control monetary policy.

JGB (Japanese Government Bond): Debt securities issued by the Government of Japan to fund its public spending and financial obligations.

Return-on-Equity (ROE): A financial metric that measures a company's profitability relative to its total shareholder equity.

Price-to-Book ratio (P/B): A valuation metric comparing a company's current market price to its book value.

Cost of capital: The minimum rate of return that a business must earn to satisfy its investors.