Buy Japan

The investment implication of Abenomics

Nomura Securities Co., Ltd.

See Appendix A-1 for analyst certification, important disclosures and the status of non-US analysts. Any authors named on this report are research analysts unless otherwise indicated.

June 2013
Nomura

Contributing authors and contacts

Yunosuke Ikeda
Managing Director Head of FX Strategy, Japan yunosuke.ikeda@nomura.com +81 3 6703 3885

Tomo Kinoshita
Managing Director Chief Economist Japan tomo.kinoshita@nomura.com +81 3 6703 1280

Naka Matsuzawa
Managing Director Chief Japan Rates Strategist naka.matsuzawa@nomura.com +81 3 6703 3864

Hiromichi Tamura
Managing Director Chief Equity Strategy Japan hiromichi.tamura@nomura.com +81 3 6703 1680

Kevin Gaynor
Managing Director Global Head of Asset Allocation Strategy kevin.gaynor@nomura.com

+44 207 102 7800

Source: Nomura

Introduction

Japan has embarked on a multi-year process

2013-2015 New direction

A multi year process

1992-2012 The problem

2015-> Success

Japan has embarked on a process from the lost decades to a very different future. Abenomics is merely the toolkit to deliver that future. Investors need to understand both the problem being addressed and what would constitute success. The application of the 3 Arrow toolkit has identifiable investment implications too. However, it is unlikely that these implication will be linear from the old Japan to the new Japan. In any event, whether successful or not Japan and its markets are likely to be an important factor for the global economy and markets for several years and therefore cannot be ignored. This presentation tries, as best as can be done today, to define what success looks like and the path from here to there.
Source: Nomura

Graceful decline, but turning into future crisis?

Abenomics Trading the toolkit Arrow 1 Arrow 2 Arrow 3

Objective achieved? What does it look like? Asset class winners and losers New Opportunities

The old Japan

Decline in growth potential and deepening deflation

The problems Decline in potential growth rate
Decline in population

The market implications

Asset

allocation

Very long cash and deposits, bonds and underweight equities

Decline in international competitiveness

Large offshore holdings

Deflation

entrenched as the government and the corporate sector failed to act when needed
Lag in restructuring balance sheets after demand shocks (1990 bubble collapse, 2008 Lehman bankruptcy shock) Fiscal stimulus lacked consistency and monetary easing fell behind the curve Current account surplus and deflation exacerbated strong JPY, pressuring corporate earnings further

Domestic credit market very small No inflation hedging required and thus small linker market Banks balance sheets swap from loans to government bond holdings

Fixed income investment behaviour becomes focused on particular modes of analysis such as carry and roll

Ballooning

government debt and risk of JGB sell-off?

Despite increases in government debt, private sectors surplus cash flows back into capital markets, thus preventing a fiscal crisis. Loss of corporate competitiveness led to a decline in foreign currency reserves, gradually depleting domestic surplus cash. Reliance on currency policies With fiscal and monetary policy failing to bring about intended results, the government would have little choice but to depend on a weak currency.

Domestic political instability and waning international influence

Source: Nomura

Potential growth declined after the 1990 bubble burst

Real potential growth rate

(%) 1.6 1.4 1.2

1.0
0.8 0.6 0.4 0.2 0.0

1995
Source: Cabinet Office

2000

2005

2010

Japans potential growth rate declined from above 4.0% to around 0.5% after the two demand shocks (i.e., collapse of financial bubble in 1990, Lehman shock in 2008).

With lower inflation rates, nominal GDP growth fell to zero

Japans GDP growth rate has been kept extremely low over the past two decades
Nominal GDP growth
25

20
Nomura Forecast (12-15)

15

10

-5
1956 1961 1966 1971 1976 1981 1986 1991 1996 2001 2006 2011

(FY)

Source: Cabinet Office, Government of Japan

And the population peaked in 2010

Population decline and an aging society are hindering growth
Long-term population trend
(mn) 140 (%) 45.0

40.0 120 35.0 100

Total Population(lhs)
80

30.0

25.0

60

20.0

% of population 65 years and over (rhs)

Estimates

15.0

40 10.0 20 5.0

0 1920

0.0 1930 1940 1950 1960 1970 1980 1990 2000 2010 2020 2030 2040 2050 (CY) 8

Note: 1)Some data missing for periods of conflict. 2) Projections are median estimates from National Institute of Population and Social Security Research data. Source: Nomura, based on Ministry of Internal Affairs and Communications, and National Institute of Population and Social Securities Research Data

Perhaps little surprise then that there has been instability in Japan politics?
The big difference is, Prime Minister Abe has won great popularity unlike several previous Prime Ministers. We finally see signs of political stabilization, which would be positive for the economy.
Cabinet support rating
cabinet support rating, % 90 80 Abe 70 60 50 40 Koizumi 30 Abe 20 10 0 01 29 Jul 09 03 05 11 Jul 04 07 29 Jul 07 09 11 11 Jul 10 13 28 Jul 13 ? LDP (majority) Dec 16? 15 Jul 16 17 CY Fukuda Hatoyama

Aso

Kan

Noda

House of Councillors Liberal Democratic Party (majority) The House of Representatives LDP (the leading party )

Democratic Party (the leading party) Democratic Party (majority) 30 Aug 09

LDP (majority) 11 Jul 05

16 Dec 12

Source: Nomura, based on Nikkei 9

And given this macro and political backdrop, debt levels have continued to grow

Primary central and local government fiscal balance

(as % of nominal GDP)

Japans government debt (vs. nominal GDP)

(as % of nominal GDP) 220

If additional stimulus is implemented in FY14/15 If no additional stimulus in FY14/15

210 200 190 180

Reduction target (half FY10 level)

-2

170 160 150

-4

-6

140 130

-8 1990 1993 1996 1999 2002 2005 2008 2011 2014 (FY)
120 2000 2002 2004 2006 2008 2010 2012 2014 (FY)

Source: Nomura and Japans MOF

Source: Nomura and Japans MOF

10

With large domestic holdings

JGBs are mainly held by domestic financial institutions
Breakdown of JGB holder (%)

Bank of Japan 7.3 2.5 8.7

12.0 Depositary institution Insurance & Pension funds General government 37.5
Households

9.7

22.2 Overseas

Note: Figures are as of CY2002. Source: Nomura, BOJ

11

Lack of growth and weak domestic capex has led to continued corporate surplus and a tiny credit market
Abenomics is trying to move frozen cash in corporate sector Targeting 70trn capex from current 60+ trn level
Cash of Japanese companies
(trn)

Private capital expenditure

(trn)

220 210 200 190 180

80

75

70trn

70

65

170
60

160 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12
55

Note: Total cash and deposits for nonfinancial business

50 2000 2004 2008 2012 (FY)

Source: Nomura, based on Bank of Japan data

12

And so while Japanese banks are some of the healthiest, they have very high loan-to-deposit ratios
Totally different from early 2000s when Japans banks faced a major NPL concern
Ranking of Banking Systems Based on Banks Balance Sheet Indicators, 2012:Q3
Japanese banks

CET1 ratio (FY12)

12%

CET1 ratio
10%

8%

6%

4%

2%
Sources: Bloomberg L.P.; SNL Financial; and IMF staff estimates. Note: AT = Austria; CH = Switzerland; DE = Germany; ES = Spain; FR = France; GR = Greece; IE = Ireland; IT = Italy; JP = Japan; NL = Netherlands; PT = Portugal; SE = Sweden; UK = United Kingdom; US = United States. The closer a banking system is to the center of the figure, the more balance sheet adjustment it needs to undertake. Rankings are based on the aggregate position for a large sample of banks headquartered in each country (more than 90 percent of the banking system in most cases) as of 2012:Q3 or as of the latest available data before then. Bank buffers are the ratio of core Tier 1 capital and loan loss reserves to impaired loans as reported in banks financial statements. The loan-to-deposit ratio is gross loans as a percentage of deposits (for Italy and Spain, adjusted for retail debt). Change in the impaired loan ratio is the annual change in impaired loans as a percentage of gross loans. Return on assets is average annualized retained earnings over the past year as a percentage of tangible assets minus derivatives. See footnotes 17 and 18 in the main text.

0% JPM BOA Deutsche

13

Source: Nomura, Company data

Barclays

MUFG

SMFG

Mizuho

HSBC

BNP

SG

Citi

Household asset allocations different from other G7 countries for good reason
Cash has been king for the long deflation period in Japan
Composition of household financial assets in Japan

Bonds, 2.1%

Investment trusts, 3.8%

TOTAL
Other total, 4.2%

Japan

Cash & deposits, 55.2% Bonds, 9.5% Cash & deposits, 14.3% Bonds, 7.0% Investment trusts, 11.8%

Insurance and pension reserves, 27.7% Equities, investments, 6.8%

USD15.9trn

Other total, 3.2%

US

Equities, investments, 32.8% Investment trusts, 7.2% Equities, investments, 14.3%

Insurance and pension reserves, 28.1%

USD54.4trn

Other total, 3.9% Insurance and pension reserves, 31.7%

Euro area

Cash & deposits, 35.8%

USD25.4trn
100%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

Source : Nomura, based on Bank of Japan data 14

Japanese households portfolios badly protected against inflation risk

A rise in CPI may push households to shift deposits that have been steadily rising from late 1980s into risk assets
Long-term household asset composition of equity and real interest rate
%
30 Equities, investments & investment trusts (lhs) Real interest rate (deposit rate - CPI (ex food & energy))(rhs)

inv, %
-5

-4 25 -3

20

-2

15

-1

0 10 1

5
79 82 85 88 91 94 97 00 03 06 09 Source : Nomura, based on Ministry of Internal Affairs & Communications and Bank of Japan data

CY
12

15

Japanese pension funds have decreased Japanese equity allocation for more than a decade
Pension funds are possible net buyers of Japanese equities other than nonresident and individual investors
Weight of Japanese Equities in Corporate Pension Funds and GPIF
(%)

Corporate Pension Funds

GPIF

35
30 25

20
15 10

5
FY01 FY02 FY03 FY04 FY05 FY06 FY07 FY08 FY09 FY10 FY11
16 Source : Nomura, based Government Pension Investment Fund and Pension Fund Association data

No surprise that equities are cheap versus historical levels

Current P/E of 16.2x still lower than post-2000 average of 19.6x
TOPIX 12 month forward P/E
(times)

90 80 70 60 50 40 30 20 10 0 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12
17 Source: Nomura, based on Tokyo Stock Exchange and Toyo Keizai data

The earthquake changed current account dynamics

Cumulative changes in trade balance

(JPY trillion, annualized) 20 15
170

Terms of trade and oil price

Cumulative change since April 2007

180 Terms of trade (lhs)

Oil price (rhs, inverted)

10 5 0 -5 -10 -15 -20 -25

-30 -35 2007

20

160 150 140

40

-16.8

130 120 110 100 90

60

80

100

-24.8 Export volume Price 2008 2009 2010 2011 Import volume Actual change 2012

120 80
70 1995

Terms of trade deteriorates

Oil price rises

140

1997

1999

2001

2003

2005

2007

2009

2011

Source: MOF, Nomura

18

Loss of nuclear generators had an impact too

Changes in nominal mineral fuels imports (from Jan-Nov 2010 to Jan-Nov 2012)
80%

Estimated capacity utilization ratio of nuclear generators in Japan

70% Upside scenario (Ikata 3, Tomari 1&2, Shiga 2, and Sendai 1&2 restart) Current schedule (Ohi 3&4 restart)

72.6%

64%
70%
53.5%

Volume contribution Price contribution Percentage changes 22.5%

60%

60%

50%

50% 38.9%

40%
30.8%

40%

6.6%

30%
2.9% 30% 57.1%
20% 32.3% 27.9% 15.8% 12.3% 1.1% 14.1%

32%

29.8% 50.1%

20%

21% 16% 15% 10% 5% 5% 5% 0% Q4 Q1 Q2 Q3 Q4 5%

10% 5% Q2 Before quake Q3 2011 Q4 Q1 0% Q2 Q3

10%

11.2% 0%

0%

2012

2013

-10% Mineral fuels Crude oil

-3.6% Petroleum products

LNG

LPG

Coal

Source: MOF, Nomura

19

FDI outflows have recovered since 2010

FDI flows in Japan

JPY bn
4,000 2,000 0 -2,000 -4,000 -6,000 -8,000 -10,000 -12,000 -14,000 -16,000 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 Overseas FDI by residents Inward FDI by non-residents

Source: Nomura and the Bank of Japan

20

Defining Success the new Japan

What is the objective?

Success Return to positive trend growth in region of 1-1.25% End psychology of deflation with return to stable positive inflation Fiscal accounts on stable footing Higher return on capital Retain culture but modernise attitudes Higher labour and social mobility Political stability at home and more influence abroad

The market implications

Asset

allocation

Increased equity holdings

Reduced cash holdings

Higher credit exposure Inflation protection to play a role Real estate included Ambiguous impact on net foreign holdings

Manage process of higher bond yields

Re-emergence of domestic credit market and linker market Leveraged loan market and securitised asset market growth Higher domestic and cross-border M&A volumes (inward FDI higher too)

Source: Nomura

22

Economic outlook: yearly

Nomuras outlook on Japans economy
, y-y, except where noted
Real GDP <Domestic demand> <Private> <Public> <Foreign demand> Private consumption Private housing investment Private capital expenditure Changes in inventory investment Public consumption Fixed public capital formation Exports Imports Nominal net exports (as % of GDP) Nominal GDP GDP deflator Industrial production Corporate goods price index Consumer price index Excl. fresh food Excl. fresh food and the impact of consumption tax rate hike GDP deflator Unemployment rate Customs cleared trade balance ( trn) Balance of goods ( trn) Balance of goods and services ( trn) Current account balance ( trn) Current account balance ($ bn) As a % of nominal GDP Source: Nomura FY10 3.4 2.6 2.5 0.1 0.8 1.7 2.2 3.6 1.0 2.0 -6.4 17.2 12.0 0.9 1.3 -2.0 9.3 0.4 -0.6 -0.9 -0.9 -2.0 5.0 5.3 6.5 5.2 16.7 194.8 3.5 FY11 0.2 1.3 1.0 0.2 -1.0 1.5 3.7 4.1 -0.5 1.4 -2.2 -1.6 5.3 -1.3 -1.4 -1.7 -1.0 1.3 -0.1 0.0 0.0 -1.7 4.6 -4.4 -3.5 -5.3 7.6 96.5 1.6 FY12 FY13 FY14 FY15 (F) (F) (F) (F) 1.2 2.5 1.8 1.9 2.0 2.3 1.2 1.2 0.8 1.6 0.9 1.4 1.2 0.7 0.3 -0.2 -0.8 0.2 0.7 0.7 1.6 2.1 0.1 0.8 5.3 6.8 0.1 -2.1 -1.5 0.4 6.3 6.8 -0.1 0.1 0.0 0.1 2.6 1.7 1.2 1.4 15.2 8.3 1.0 -8.9 -1.3 4.0 8.5 9.4 3.8 3.0 5.0 5.9 -2.2 -2.5 -2.0 -1.5 0.3 2.4 4.1 3.2 -0.9 -0.1 2.2 1.2 -3.4 3.7 3.5 3.4 -1.1 1.5 3.9 2.1 -0.3 0.3 2.9 1.8 -0.2 0.4 3.0 1.9 -0.2 -0.9 4.3 -8.2 -6.9 -9.5 4.3 51.4 0.9 0.4 -0.1 3.9 -10.3 -8.7 -9.7 6.0 59.5 1.2 0.7 2.2 3.8 -9.0 -7.5 -8.1 8.9 84.5 1.8 1.1 1.2 3.5 -7.6 -6.0 -6.5 11.2 103.6 2.1 CY10 4.7 2.9 2.5 0.4 1.7 2.8 -4.5 0.3 0.9 1.9 0.7 24.4 11.1 1.2 2.4 -2.2 16.4 -0.1 -0.7 -1.0 -1.0 -2.2 5.0 6.6 8.0 6.6 17.9 203.9 3.7 CY11 -0.6 0.3 0.3 -0.1 -0.9 0.4 5.5 3.3 -0.5 1.4 -7.5 -0.4 5.9 -0.9 -2.5 -1.9 -2.3 1.5 -0.3 -0.3 -0.3 -1.9 4.6 -2.6 -1.6 -3.4 9.6 119.0 2.0 CY12 2.0 2.9 1.8 1.1 -0.9 2.3 3.0 2.0 0.0 2.6 12.5 -0.1 5.4 -2.0 1.1 -0.9 -0.3 -0.9 0.0 -0.1 -0.1 -0.9 4.3 -6.9 -5.8 -8.3 4.8 60.9 1.0

Forecast assumptions
CY13 CY14 CY15 FY12 (F) (F) (F) 1.6 2.5 1.7 1.6 2.0 1.0 USD/JPY rate 83.0 0.8 1.5 1.1 (average) 0.8 0.4 -0.1 0.0 0.5 0.7 1.6 1.2 0.3 Consumption tax rate (end- 5.0 7.9 1.4 -1.1 fiscal year) -2.5 5.9 6.5 0.0 0.0 0.1 1.9 1.2 1.4 WTI spot 110.0 price 9.9 4.6 -7.1 1.4 8.0 9.2 Source: Nomura 1.5 5.3 5.8 -2.5 -2.2 -1.7 1.0 4.3 3.2 -0.6 1.8 1.5 -0.2 4.9 3.1 1.0 3.4 2.3 -0.1 2.4 1.9 0.1 2.4 1.9 0.1 -0.6 4.0 -10.6 -9.1 -10.4 5.0 51.4 1.0 0.7 1.8 3.8 -9.3 -7.8 -8.4 8.2 79.1 1.6 1.0 1.5 3.6 -8.2 -6.7 -7.2 10.4 96.4 2.0 FY13 FY14 FY15

101.0

105.0

108.0

5.0

8.0

10.0

100.0

97.0

96.0

23

The 3 Arrows toolkit for achieving the policy objective

What is the package of tools?

Observations
This is a multi-year process. There are several failure modes and dates to get through. Ultimate success is not guaranteed, which implies market returns will not move in a straight line.

Three Arrows to re-engineer Japans economic engine

Flexible fiscal policy represents three arrows under Abenomics standsfor the effects that have already materialised while shows effects that have partially materialised

Rise in corporate profit Financial markets

Creation of effective demand = higher growth Higher wages Wealth effects Increase in private consumption

Increase in public investment

Reforms like this almost always generate unintended consequences and unknown unknowns we have to keep monitoring.
However, falling at the first hurdle seems unlikely plus sensible policymakers always make the cost of reversal higher than the cost of moving on (c.f. the euro area). Investors may believe or be sceptical but the process is likely to be live and important globally for several years.
Source: Nomura

Aggressive monetary policy

Higher stock prices Weaker yen

Growth Increase in corporate capex Increase in exports strategy (including tax reform)

Expectation effects

Higher importprices

Shrinkage of deflation gap

Break away from deflation

25

FIRST ARROW: historic move to ease monetary conditions

The BOJ introduced quantitative and qualitative monetary easing that far exceeded market expectations (4 April 2013)

Increase the amount of JGB purchases

Increase the net purchase of JGBs to JPY50trn per year for both 2013 and 2014

Previous plan was net JGB purchases of about JPY30trn in 2013 and JPY23trn in 2014

Extend the maturity of JGBs that the BOJ purchases

Extend the average remaining maturity of the JGBs that the BOJ purchases to about 7 years

Aimed at lowering bond yields across the yield curve

Increase the purchase of ETFs and J-REITs

Increase the holdings of ETFs and J-REITs by JPY1trn and JPY30bn, respectively, for both 2013 and 2014

More additional risk-asset purchase than the market had expected

Set monetary base as an operating target

Change from the previous operating target of "uncollateralized overnight call rate"

Targeting the monetary base has been a long-held proposal by Deputy Governor Iwata. There was also an intention to set a more realistic operation target.

Source: The Bank of Japan and Nomura Securities Co.

26

Aiming to control monetary base rather than interest rate

Monetary base: actual value and target by the BOJ

JPY, trn 300 Current account 250 Currency in circulation Banknote 200 Monetary base 200.0 target 270.0

150

132.0

100

50

0 1980 1985 1990 1995 2000 2005 2010 2014

Note: December's average figures are used for actual figures. For target figures, year-end figures are used. Source: The Bank of Japan and Nomura Securities Co.

27

The BOJ expanding its balance sheet aggressively

The Bank of Japans balance sheet
Breakdown of the BOJ's Balance Sheet and their Outlook Others
Monetary base

Stock (amount outstanding)

JGBs (Outright Purchases)

Loan Support Program

Commercial paper

Pecuniary Trusts IndexLinked Corporate Exchangebond Traded Funds[ETFs ] Held as Trust Property

Pecuniary Trusts Japan Real Estate Investment Trusts [JREITs] Held as Trust Property

Shortterm JGBs (net)

Fund supply operation s against pooled collateral

FundsSupplying Operation to Support Financial Institution s in Disaster Areas

CP (repos)

Money in trust (stock)

Loans

Current acct deposits

Bank notes

Coins

BoJ Accounts/Total Assets

11

1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 1 2 3 4 5 6 7 8 9 10 11 12

59.1 60.9 62.0 66.1 70.7 77.5 81.7 89.2 91.3 67.9 70.1 70.7 73.2 76.3 77.5 79.9 82.9 81.7 86.1 88.9 89.2 91.3 92.9 91.3 98.1

0.3 1.6 1.5 2.0 1.6 1.9 1.4 2.1 1.2 1.7 1.6 1.6 1.6 1.7 1.9 1.7 1.5 1.4 1.5 1.9 2.1 2.0 2.0 1.2 1.4

0.2 0.6 1.1 1.5 2.0 2.2 2.7 2.9 2.9 1.7 1.8 2.0 2.0 2.2 2.2 2.4 2.6 2.7 2.9 3.0 2.9 3.0 3.0 2.9 2.9

0.2 0.3 0.6 0.8 0.8 1.3 1.4 1.5 1.5 0.8 0.8 0.8 0.9 1.1 1.3 1.3 1.3 1.4 1.4 1.5 1.5 1.5 1.5 1.5 1.7

0.02 0.02 0.05 0.06 0.07 0.09 0.10 0.11 0.12 0.07 0.07 0.07 0.08 0.09 0.09 0.09 0.09 0.10 0.11 0.11 0.11 0.11 0.12 0.12 0.13

82.6 66.1 72.5 72.5 64.3 60.6 62.7 59.3 63.8 64.7 69.8 64.3 63.4 61.5 60.6 60.1 61.5 62.7 61.7 60.9 59.3 58.5 60.6 63.8 67.1

18.2 19.3 22.4 24.1 16.6 16.7 21.2 24.5 34.0 14.6 14.5 16.6 17.2 16.8 16.7 17.8 19.7 21.2 21.5 22.7 24.5 27.3 29.0 34.0 36.0

53.9 35.3 39.4 36.0 35.4 32.4 30.7 26.9 21.7 37.2 42.6 35.4 34.7 33.3 32.4 31.0 30.6 30.7 29.0 27.0 26.9 23.3 23.6 21.7 23.1

0.2 0.4 0.5 0.5 0.4 0.4 0.4 0.4 0.5 0.5 0.5 0.5 0.5 0.4 0.4 0.4 0.4 0.4 0.4 0.4 0.4 0.4 0.4 0.4

0.6 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0

1.5 1.5 1.4 1.5 1.4 1.4 1.3 1.4 1.4 1.5 1.5 1.4 1.4 1.4 1.4 1.4 1.4 1.3 1.4 1.4 1.4 1.4 1.4 1.4 1.4

0.2 0.1 0.1 0.1 0.1 0.0 0.0 0.0 0.0 0.1 0.1 0.1 0.1 0.1 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0

126.2 117.0 118.0 125.1 119.8 128.9 129.4 138.5 146.0 114.6 113.0 119.8 123.1 115.7 128.9 122.5 122.6 129.4 128.5 125.9 138.5 130.9 131.3 146.0 155.3

40.8 33.2 34.6 36.5 34.4 43.1 44.0 47.2 58.1 29.9 28.0 34.4 36.4 30.9 43.1 36.8 37.0 44.0 42.8 39.7 47.2 43.7 43.9 58.1 66.2

80.9 79.3 78.9 84.0 80.8 81.2 80.9 86.7 83.4 80.2 80.5 80.8 82.2 80.3 81.2 81.1 81.1 80.9 81.3 81.7 86.7 82.6 82.9 83.4 84.5

4.5 4.5 4.5 4.5 4.5 4.5 4.5 4.6 4.5 4.5 4.5 4.5 4.5 4.5 4.5 4.5 4.5 4.5 4.5 4.5 4.6 4.6 4.5 4.5 4.6

142.4 129.6 137.7 143.0 139.5 143.6 149.9 158.4 164.3 136.9 144.2 139.5 141.2 142.8 143.6 145.5 150.0 149.9 153.7 156.4 158.4 159.8 163.5 164.3 174.7

12

3.3 3.4

13 12

3.3 3.3 3.3 3.4 3.4

13

1 2 3 4

Outlook End-2013 End-2014 140 190 13.0 18.0 2.2 2.2 3.2 3.2 2.5 3.5 0.14 0.17 59.0 72.9 200.0 270.0 107.0 175.0 88.0 90.0 5.0 5.0 220.0 290.0

Source: The Bank of Japan and Nomura Securities Co.

28

The BOJ set to buy about 75% of newly-issued JGBs

Comparison of monthly JGB issuance with BOJ purchases of JGBs
Gross JGB issuance per month (trn) Type of JGBs Bonds w ith coupons Amount of JGBs to be purchased by the BOJ per month (trn) Type of JGBs Bonds w ith coupons Remaining maturity Up to 1 year 0.22

2-year bonds 5-year bonds 10-year bonds 20-year bonds 30-year bonds 40-year bonds Inflation-linked bonds

2.90 2.70 2.40 1.20 0.57 0.13 0.05

5.60

>
< >

More than 1 year and up to 5 years More than 5 years and up to 10 years More than 10 years

3.003.50

3.003.50 0.801.20

1.90

>

Inflation-linked bonds Floating-rate bonds

0.01 0.07 7.50

Total

9.95

Total

Note: Bond issuance data are monthly amounts for FY13 while the bond purchase figures are monthly averages for May 2013 through end-2014. Source: Japan Ministry of Finance, the Bank of Japan and Nomura Securities Co.

29

The maturity of JGBs held by the BOJ set to rise

JGBs held by the Bank of Japan as of end-February 2013

JPY trn

Remaining maturity (years)

<1 13 35 510 1020 20+ Total

JGB held by the BOJ

APP
9.5 16.9 26.3

Other
14.1 15.3 9.8 17.0 8.1 0.6 65.0

Total holdings
23.6 32.2 9.8 17.0 8.1 0.6 91.3

Source: Nomura Global Economics from the BOJ and the MOF of Japan

30

Longer maturity for BOJ purchases to help JGB market

Amount of issued JGBs outstanding and average years to maturity

(trn) 160 140

Issued JGBs outstanding (lhs) Average years to maturity (rhs)

(years) 9

8 7 6 5 4

120
100

80
60

40
20

3 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 (FY)
31

Note: Actual figures through FY11; budget draft for FY12 Source: Nomura, based on MOF data

Japan to exit from deflation environment

Forecasts of the majority of Policy Board Members
% Forecasts of the majority of Policy Board Members Upper bound Forecasts of the majority of Policy Board Members Mediun

2.5 2.0

Forecasts of the majority of Policy Board Members Lower bound Nomura's forecast

2.2 1.6 1.9

1.5 1.4 1.0 0.5 0.4 0.8 0.7 0.7 1.1 0.9

0.0
-0.2 -0.5 2012 2013 2014 2015
Fiscal year average
Source: Nomura, based on BOJ and Cabinet Office data

32

2% inflation is a challenging target

Core CPI (all items less fresh food) and output gap simulation
(% y-y) 3 2 Core CPI (lhs) Supply/demand gap (lagged by 2 quarters, rhs) 4 2 (%) 6

1
0 -1 -2 -3

0 -2

-4
-6 -8 -10

Note: (1) Actual output gap figures are Cabinet Office assumptions, forecasts by Nomura. (2) We assume potential growth rate of 0.5%, the same as the figure used by the BOJ. For estimates, we use the median forecast of the majority of policy board members, as shown in the BOJ's Outlook Report (April). (3) Core CPI is extrapolated from the future supply/demand gap. Source: Nomura, based on BOJ, Cabinet Office, and MIAC data

95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16
(CY)

33

2% inflation target is a challenge

Historical CPI inflation

% y-y
10 Headline CPI Core CPI ( = CPI excluding f resh f ood) Core core CPI ( = CPI excluding energy and f ood) 2% level

-2

-4 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12

Note: Core CPI is CPI excluding fresh food. Source: Nomura, based on Ministry of Internal Affairs and Communications data

34

Low pass-through rate when cost rises

Elasticity of consumer goods prices to manufacturers input prices in inflationary and deflationary phases

Feb 80Mar 83 Jul 88Oct 91 Nov 03Jun 08 0.1 2.2

3.3

Note: Elasticity values were calculated for periods when both manufacturers input prices and consumer goods prices were rising or falling in unison, taking into consideration lag times and using only those months when the correlation coefficient was at its highest. Source: Nomura, based on MIAC and BOJ data

Surge phase Fall phase

Oct 84Oct 87 Aug 93Jun 96 Jul 97Jul 03 Jun 08Apr 11 0

0.1 0.3 1.0 Elasticity by phase 0.5 1 2 3 4 (elasticity)

35

Loans increase gradually

Domestic bank loan growth

% y-y
10 Total loans Individuals Large enterprises Small enterprises

-5

-10

-15 02 03 04 05 06 07 08 09 10 11 12 13

Source: Nomura, based on CEIC and BOJ data

36

Watch out for rent and electricity prices

CPI weight Breakdown of core CPI inflation into key factors

Item Food Weight 25.25 4.00 5.32 21.22 18.65 7.04 3.17 3.45 4.05 4.28 14.21 2.10 8.20 3.91 3.34 11.45 5.69 100.00

% y-y
4

Fresh food Eating out Housing Rent Fuel, light & water charges Electricity Furniture & household utensils Clothes & Footwear Medical care Transportation & communication Public transport Private transport Communication Education Culture & recreation Miscellaneous Total
Source: Cabinet Office and Nomura

Other factors Electricity Rent Core CPI

-1

-2

-3 85 87 89 91 93 95 97 99 01 03 05 07 09 11 13
Source: Cabinet Office, CEIC database and Nomura

37

SECOND ARROW: large economic impact through Q1 2014

Forecasts for public works spending as part of reconstruction efforts and economic stimulus
(annualized, bn) 2,500 FY12 2nd economic stimulus FY13 reconstruction package package

FY12 1st economic stimulus package 2,000

FY14 reconstruction package

FY14 economic stimulus package FY12 budget for reconstruction FY11 4th budget
FY15 economic stimulus package

1,500

1,000
FY11 2nd budget 500

FY12 supplementary budget

FY11 3rd budget

FY11 1st supplementary budget 0 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q

2011

2012

2013

2014

2015

Source: Nomura Global Economics and MOF

38

Economic packages

Emergency economic stimulus package to revive the Japanese economy

JPY trn
Measures Reconstruction and disaster management Acceleration of post-quake reconstruction Disaster prevention and mitigation Wealth creation through growth Enhancing growth potential by attracting private investment Support for SMEs, small businesses, and agriculture/forestry/fisheries Support for Japanese companies overseas Training and employment Ensuring the livelihood of the public and the revitalization of regional areas Public livelihood (healthcare, childcare, etc) Regional revitalization (help for farmers, etc) Help with regional funding, rapid implementation of these measures

Fiscal outlay
3.8 1.6 2.2 3.1 1.8 0.9 0.1 0.3 3.1 0.8 0.9 1.4

Spending 5.5 1.7 3.8 12.3 3.2 8.5 0.3 0.3 2.1 0.9 1.2

State's share of multiyear public works projects

Total for economic stimulus measures Of which, public works spending Implementation of 50% government contribution to state pensions, etc Total for supplementary budget

0.3
10.3 4.7 2.8 13.1

0.3
20.2 6.8

20.2

Note: Figures for public works spending are Nomura estimates based on Cabinet Office estimates of project sizes. Source: Nomura, based on MOF and Cabinet Office data

39

Consumption tax is set to be the biggest source of tax revenue

Tax revenue by major taxes

(trn)
20 18 16 14 Nomura est Income tax Corporate tax Consumption tax

12
10

8
6 4
Source: Nomura, based on MOF data

(FY) 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15
40

Fiscal challenges facing Japan

Primary central and local government fiscal balance

(as % of nominal GDP)

Japans government debt (vs. nominal GDP)

(as % of nominal GDP) 220

If additional stimulus is implemented in FY14/15 If no additional stimulus in FY14/15

210 200 190 180

Reduction target (half FY10 level)

-2

170 160 150

-4

-6

140 130

-8 1990 1993 1996 1999 2002 2005 2008 2011 2014 (FY)
120 2000 2002 2004 2006 2008 2010 2012 2014 (FY)

Source: Nomura and Japans MOF

Source: Nomura and Japans MOF

41

THIRD ARROW: growth strategy under a new framework

Framework for planning and implementing Abenomics

Microeconomic policy
Headquarters for Japans Economic Revitalization
Consists of ministers, h eaded by PM Abe

Macroeconomic policy
Council on Economic and Fiscal Policy
collaboration
Consists of ministers, BOJ Governor and private-sector participants, headed by PM Abe Will announce in June the Basic Policies for Economic and Fiscal Management and Structural Reform

Industrial Competitiveness Council

Consists of ministers and privatesector participants, headed by PM Abe Submitted a proposal in June 2013

collaboration

Regulatory reform panel

Consists of private-sector participants Will submit a proposal in June 2013

Source: Nomura Global Economics and CEIC data

42

Growth strategy will be announced in mid-June

Growth strategy-related schedule
By mid-May Council for Science and Technology Policy and Regulatory Reform Council to report their discussions Mid-May Ahead-of-schedule announcement of growth strategies? (second time) Mid-May Establishment of agriculture industry-related council within the Prime Ministers Office
By end-May Education Rebuilding Implementation Council to report its discussions

From mid-May Industrial Competitiveness Council to formulate growth strategies

By 1718 June Government to officially announce growth strategies (and the Basic Policies for Economic and Fiscal Management and Structural Reform)

28 June End of current Diet session 4 July (tentative) Official announcement of Upper House elections

21 July (tentative) Upper House elections

Post-Upper House elections Submission to the Diet of the Act to Strengthen Industrial Competitiveness (provisional title) Further debate in the Regulatory Reform Council and other forums on employment system reform

Source: Nomura, based on various news reports

43

Mr. Abes first announcement

Growth strategies announced by Prime Minister Abe at 19 April press conference
Category Foreign policy Target Advance economic partnership talks with Asia-Pacific and Europe Launch economic diplomacy drive, including overseas visits by top officials Promote concept of leading-edge healthcare centers on PM's visit to Russia Promote concept of leading-edge healthcare centers on PM's visit to UAE, aim to reach agreement Medical services and healthcare Launch public-private initiative Medical Excellence Japan with view to promoting Japanese healthcare internationally Provide around 110bn of assistance for iPS cell research over 10 years Amend Pharmaceutical Affairs Act in order to significantly reduce screening times for regenerative medicine products Allow outsourcing of cell culturing to private sector Shorten certification review periods for medical equipment and support market entry by smaller companies Move from an approval system to a registration system for medical equipment manufacturers

Establish a Japanese version of the National Institutes of Health (NIH)

Promote measures to tackle intractable diseases Labor and employment Facilitate shift of human resources from mature industries to growth industries (by increasing support subsidies for labor movement, etc) Expand trial employment system that supports three-month trial employment Establish a voluntary career advancement system that helps individuals gain qualifications Extend period in which third-year university students are prohibited from job hunting to March, from December Introduce mandatory practical English tests for public sector workers

Women in the workplace

Call on Japanese industry to ensure at least one female is appointed to the board of every listed company
Target women accounting for at least 30% of leadership positions by 2020 Aim to eliminate childcare waiting lists by FY17 Extend eligibility for financial support to extended-hours childcare at kindergartens Ease subsidy requirements for childcare facilities inside business premises Call on Japanese industry to allow childcare leave to be taken until a child reaches three years old Provide support to individuals returning to the workplace following childcare leave (retraining subsidies, etc)

Source: Nomura, based on Prime Ministers Office data

44

Mr. Abes second announcement

Growth strategies announced by Prime Minister Abe on 17 May

Growth strategies included for the first time Measures to promote capex using leases Break from practice of requiring startups to provide personal guarantees Easing of visa requirements for people from Southeast Asia, including Thailand, Malaysia, and Vietnam Creation of plan to double agricultural income Establishment of agricultural development fund Direct payment system for farming households Establishment of public-private Cool Japan Promotion fund Creation of single point of contact for processing rights related to content exports Some numerical targets for growth strategies unveiled at news conference Current Private-sector capex 63trn Overseas infrastructure order receipts 10trn Agricultural income Agriculture, forestry, and fisheries exports 450.0bn Market size of senary industry 1trn Number of visitors to Japan 8mn people a year Exports of broadcasting content Non-Japanese university professors Number of universities ranked among the world's top 100 universities 2 universities

Target 70trn 30trn Double 1trn 10trn 1020mn 3x or more Double 10 universities

Period 3 years 2020 10 years 2020 10 years 5 years 3 years 10 years

Note: Of the growth strategies mentioned in Prime Minister Shinzo Abe's speech on 17 May, we have listed those that are not among the growth strategies proposed by the Industrial Competitiveness Council and theme-based committees. Source: Nomura, based on Prime Minister Shinzo Abe's speech

45

Mr. Abes third announcement

Growth strategies announced by PM Abe on 5 June

46

Key components of growth strategy (1)

Growth strategy proposals by the Industrial Competitiveness Council and theme-based committees(1)
Agenda items for theme-based committees and growth strategy candidates Promoting industrial metabolism Encourage industry consolidation, business restructuring Create new industries (businesses), further expand existing industries Maintain the industrial base Make the next five years a period of focused structural reforms to industry. Initiatives to include the introduction of a Japanese limited liability company (LLC) system (whereby profit/loss can be offset between parent and subsidiary); greater clarification of rules and regulations for termination of employment; simplification/expansion of angel investor tax procedures; a tax regime to promote intra-company ventures, carve outs and spinoffs; incentives for replacement of aging facilities and equipment; and corporate tax breaks to stimulate investment within Japan and from overseas. Strengthening of the human resource pool, and employment reforms Promote measures to tackle the dwindling birth rate Reform employment Reform education Promote employment of youth, women and the elderly

Examine ways to stem the population decline and maintain the population at a certain size. Examples include: tax breaks for companies that offer childcare support; use of TOEFL in university entrance exams and other areas; establishment of international universities either by invitation to leading overseas universities or jointly by Japanese universities; large-scale expansion of student capacity at technical colleges; creation of mid-to-long-term internships as part of formal education programs; greater diversification of work contracts (fixed contracts of over three years, region-, job- and project-specific contracts, etc); rationalization/clarification of rules of employment; wider scope of eligibility for government subsidies, including for trial employment; regional transfer and opening-up to the private sector of the Hello Work scheme; establishment of social systems to support September university entrance and Gap Year programs. Enhancing Japan's competitiveness as a place to do business Improve the regulatory environment Enhance traffic and urban infrastructures Internationalize the business environment Augment measures to stimulate regional economies Rectify high-cost structures Improve urban environments Promote Abenomics strategy zones (tentative name) that feed directly through to economic growth Make effective use of government assets and household financial assets Take steps to rectify areas that make it difficult to do business globally. Examples include: reduction in corporate tax; international leading-edge tests and their trial introduction in special zones; separation of power transmission & distribution operations at an early stage (introduction of "negawatt" trading by this summer); implementation of the internet/ICT AutoBAHN concept; extensive improvements to airports in the greater Tokyo area; easing of regulations on plot ratios and property uses in metropolitan areas; measures to make active use of big data and open data; promotion of Abenomics strategy zones (tentative name); promotion of Doshusei system; sale of low-priority government assets; study into best practices for investing public and quasi-public funds and managing associated risk. Achieving balanced supply-demand for clean, economic energy Supply-side (procurement) initiatives Demand-side (consumption) initiatives Distribution initiatives Adopt policies to support the areas of supply, demand and distribution/logistics in order to secure an affordable and stable supply of the energy Japan needs. Supply-side initiatives include the early restart of nuclear power plants verified as safe, greater efficiencies in coal-fired thermal power generation via use of gas turbine combined cycle and other systems, sourcing of LNG more widely and affordably, deregulation to promote wind power generation. Demand-side initiatives include the introduction of a purchasing scheme for cogeneration power, the introduction of energy-saving homes equipped with energy management systems, the development and promotion of next-generation automobiles, installation of smart meters and other infrastructure (demandresponse infrastructure), promotion of the Energy Bank concept (battery development), study into possible introduction of summer time. Initiatives in the area of distribution include electricity system reform (the establishment of wide-area regional transmission organizations, full liberalization of retail electricity sales) and the strengthening of electricity cooperation (expansion of capacity of systems to convert frequency).

Note: The above lists various items presented by theme-based committees prior to the Industrial Competitiveness Council meeting of 23 April. Source: Nomura, based on Industrial Competitive Council materials

47

Key components of growth strategy (2)

Growth strategy proposals by the Industrial Competitiveness Council and theme-based committees(2)
Agenda items for theme-based committees and growth strategy candidates Creating a long-living society Build a society in which people can live a healthy, long life Enable people to return to normal life quickly via access to high-quality healthcare

Provide impetus to the healthcare industry, build a society in which everyone can receive the world's highest levels of healthcare Build a society in which the health of the populace supports economic growth

Consider taking the following steps to create a society in which people live long and healthy lives: lay foundations for affordable, simple medical consultations ("one-coin consultations"); lower medical fee deductions for the elderly; promote iPS cell research; ease regulations for approval of medical equipment; introduce a Japan-style NIH system and manage budgets of relevant ministries/agencies on an integrated basis; introduce a "my number" system and basic income program; eliminate elderly waitlists for special homes for the aged; create a healthcare REIT market; conduct a national debate on broader acceptance of migrant workers. Expand agriculture exports and boost competitiveness of agriculture industry Consolidate farmland Encourage corporate entry into agriculture industry (revise requirements for gaining status of agricultural production corporation) Set up growth industry fund for agriculture, forestry and fisheries (sixth-order industry fund) Agricultural special zones Agricultural export special zones Maintain functions of farming communities

Provide direct income compensation Promote greater industrialization of agriculture and use of ICT Human resource development and R&D Establish an export structure
Public-private initiatives with overseas partners (such as mutually beneficial partnerships in food, energy) Initiatives in forestry/fishery industries

Reorient agriculture industry to one focused on the consumer rather than the producer, and aim to turn agriculture into a growth industry and an export industry. Specific initiatives include: deregulation to support large-scale business enterprise in agriculture; use of trusts to match farmland to producers; incentives to increase use of vegetable factories; establishment of agricultural schools and business schools; creation of an accreditation system to boost value added via introduction of Japan-style agricultural occupancy condition (AOC) scheme; establishment of agricultural export special zones; creation of agricultural export business model with the aim of achieving Japan-style "food valleys"; construction of healthcare and long-term care facilities in farming communities. Enhancement of science & technology innovation and IT Appreciably strengthen frameworks for promoting innovation in science & technology Step up public-private R&D investment Strengthen activities to support innovation by the private sector

Enhance functions of universities and public research institutes Enhance IP strategies, standardization strategies Consider the following measures to promote innovation as a key source of industrial competitiveness: Reorganize the existing Council for Science and Technology Policy and strengthen its command functions; set up the FIRST-II program as a successor to the FIRST project for leading-edge R&D; ensure an equal footing in terms of plant, property and equipment tax, etc; provide IP support for small and midsize enterprises.

Note: The above lists various items presented by theme-based committees prior to the Industrial Competitiveness Council meeting of 23 April. Source: Nomura, based on Industrial Competitive Council materials

48

The TPP should benefit Japans economy

Impact of TPP on GDP growth

Impact on GDP (JPYtrn) 3.0 0.5 2.6 -2.9 3.2

Item

% GDP

The government looks likely to underestimate the real economic impact of the TPP as it merely takes into account the impact from reducing tariffs to zero. The TPPs actual benefits stem not only from reduced tariffs but also from (1) harmonized trade rules, (2) liberalized service trade, and (3) fewer restrictions on cross-border investment activity. The TPP is also likely to generate further benefits by spurring negotiations for a Japan-China-Korea FTA and RCEP (ASEAN+6).

Consumption Investment Exports Imports Net impact on GDP growth

0.61 0.09 0.55 -0.60 0.66

Source: Nomura, based on the Government of Japan

49

The TPP should benefit Japans economy

Impact of TPP on Japans GDP growth %

3. 0 TPP 12 (reducing tariff and non -tarrif barriers and liberalization of service and investment) TPP 16 (reducing tariff and non -tarrif barriers and liberalization of service and investment) 2.41 2. 02 2. 0 1.69 1. 5

2. 5

1.96

1. 0

Government's estimate
0. 66

0. 5
0.24 0.0 After 10 years 2015

0. 27

2020

2025

Note: TPP 12 shows impact when the current negotiating 12 countries join TPP while TPP 16 assumes the participation by not only the existing participants but also Korea, Indonesia, Philippines and Thailand Source: Nomura from the Government of Japan and Asia Pacific Trade

50

Other areas of growth strategy

New growth strategies featured in newspaper reports (including items under consideration)
Introduction of special zones, including Abenomics strategic zones Revival of domestic infrastructure using PFIs Export of high-efficiency coal-fired power generation technology Easing of regulations on industrial robot installation (to reduce factory construction costs) Initiatives to promote wider use of affordable long-term care robots Establishment of "human resource bank" (tentative name) as a means of providing support to SMEs when female workers take maternity and childcare leave

Initiatives to raise minimum wage Easing of visa restrictions for Southeast Asians (Thailand, Malaysia, Vietnam, etc) Placement of Japan tourism advertisements in overseas magazines and on television Study into legalizing casinos Establishment of farmland middle management organization (tentative name) to support consolidation of farmland, elimination of uncultivated farmland

Study into export of agricultural production data system in which produce cultivation technology is collated in digital form

Introduction of private-sector English language tests such as TOEFL as part of career bureaucrat examinations for new ministry and agency workers from FY16

Note: Collated from articles between 23 April and 9 May in the Nikkei, Yomiuri Shimbun, Asahi Shimbun, Mainichi Shimbun, and Sankei Shimbun. Includes items still under consideration, so all may not be included in the final growth strategies. Source: Nomura, based on various news reports

51

Investment themes: Equities

Japan again: Japanese equity market has been increasingly active

Market turnover has reached the historically high level
Historical market turnover of TSE 1st section (daily)
(mn of shares)
7,000

6,000

5,000

4,000

3,000

2,000

1,000

0 80 81 83 84 86 87 88 90 92 93 95 96 98 01 03 05 06 08 10 11 1979 2000 13

(FY)
53

Source: Nomura, based on TSE data

Japan again: Recent TOPIX has exceeded 20-year moving average

Japanese stock market has seen a sudden surge after the long slump
Historical trend of TOPIX
3,500 TOPIX 3,000 20-yr moving average

2,500

2,000

1,500

1,000

500

0 1968

72

76

80

84

88

93

98

2003

08

13

(FY)
54

Source: Nomura, based on TSE data

Market outlook: Corporate earnings and stock prices

Estimated recurring profit levels returning to pre-Lehman-crisis levels, while the index is still at half the preLehman level
Russell/Nomura Large Cap Recurring Profits and TOPIX
(trn)

TOPIX

40 35 30 25

Russell/Nomura Large Cap Recurring Profits (lhs)

TOPIX (rhs)

2,000 1,800 1,600 1,400

20 1,200 15 10 5 0 95 97 99 01 03 05 07 09 11 13 15 1,000 800 600 FY

55

Note: Latest data as of 21 May. Recurring profits for FY12 and thereafter are based on Nomura estimates Source: Nomura, based on Tokyo Stock Exchange

Market outlook: historically low P/E supporting bullish outlook

Current P/E of 16.2x still lower than the post-2000 average of 19.6x
TOPIX 12 month forward P/E
(times)

90 80 70 60 50 40 30 20 10 0 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12
56 Source: Nomura, based on Tokyo Stock Exchange and Toyo Keizai data

Market outlook: Challenge, openness and innovation are key

Emerging new business would be a further catalyst for Japans market
New business opening rate and Nikkei225
Nikkei225(lhs) 45000 40000 9 35000 8 30000 25000 20000 15000 5 10000 4 5000 7 New business opening rate(rhs)

%
10

0
81 86 91 96 01 06 11
Source: Nomura, based on MHLW data

CY

57

Market outlook : What does the success of Abenomics imply?

We estimate 2018 N225 at the 25,000 level, based on 1,650 EPS & 15x P/E
Nikkei 225 and corporate profits
\ 40,000 Nikkei Average (lhs) N225-EPS (rhs) N225-EPS \

35,000

30,000

500 0

2,000

1,500

25,000

1,000

20,000

15,000

10,000

5,000

0 85 90 95 00 05 10 15 yy

-500

Source: Nomura from Bloomberg data

58

Japanese Banks are healthy compared with US and EU Banks

Totally different from early 2000s when Japans banks faced major NPL concerns
Ranking of Banking Systems Based on Banks Balance Sheet Indicators, 2012:Q3
Japanese banks

CET1 ratio (FY12)

12%

CET1 ratio
10%

8%

6%

4%

2%
Sources: Bloomberg L.P.; SNL Financial; and IMF staff estimates. Note: AT = Austria; CH = Switzerland; DE = Germany; ES = Spain; FR = France; GR = Greece; IE = Ireland; IT = Italy; JP = Japan; NL = Netherlands; PT = Portugal; SE = Sweden; UK = United Kingdom; US = United States. The closer a banking system is to the center of the figure, the more balance sheet adjustment it needs to undertake. Rankings are based on the aggregate position for a large sample of banks headquartered in each country (more than 90 percent of the banking system in most cases) as of 2012:Q3 or as of the latest available data before then. Bank buffers are the ratio of core Tier 1 capital and loan loss reserves to impaired loans as reported in banks financial statements. The loan-to-deposit ratio is gross loans as a percentage of deposits (for Italy and Spain, adjusted for retail debt). Change in the impaired loan ratio is the annual change in impaired loans as a percentage of gross loans. Return on assets is average annualized retained earnings over the past year as a percentage of tangible assets minus derivatives. See footnotes 17 and 18 in the main text.

0% JPM BOA Deutsche

59

Source: Nomura, Company data

Barclays

MUFG

SMFG

Mizuho

HSBC

BNP

SG

Citi

Signs of leveraging increasing by Japanese companies; bank lending steadily increasing

Loan growth of Japanese banks y-o-y

(%)

5 4 3 2

1 0 -1
-2 -3 -4 -5 -6 01 02 03 04 05 06 07 08 09 10 11 12 13
60
Source: Nomura, based on BOJ

Individual investors starting to come back into the Japanese equity market

Share of brokered trading turnover on Japans three main markets

(%)

Net subscription of publicly offered Japanese equities investment trusts

(bln yen)

80

Nonresident investors

1,000

70

800

60

600

50

400

40

200 Retail investors 0

30

20

-200

-400 Jul-10 Jan-11 Jul-11 Jan-12 Jul-12 Mar-10 Mar-11 Mar-12 Jan-13 Nov-10 Nov-11 May-10 May-11 May-12 Nov-12 Sep-10 Sep-11 Sep-12 Mar-13 10
Japanese institutional investors

(CY) 00 01 02 03 04 05 06 07 08 09 10 11 12 13

Source: Nomura, based on Tokyo Stock Exchange

Source: Nomura, based on Japan Investment Trusts Association

May-13 61

Implementation of individual savings account from Jan 2014 has big potential to move retail investors cash in to riskier assets

Value of stock ISA's in UK

(bln pounds)

Composition of household financial assets in Japan, the US, and Europe

Bonds, 2.1% Investment trusts, 3.8% Japan (USD 15.5 trn) Cash & deposits, 55.2% Investment Bonds, 9.5% trusts, 11.8%
116.1

200 180 160 140 120 100 80 60 46.8 40 26.3 20 0 00 01 02 03 04 05 06 07 08 09 10 16 30.3 34.5 55.1 80.1 78.6 70.4 173.5

192.7

Other total, 4.2% Insurance and pension reserves, 27.7%

Equities, investments, 6.8%

US Cash & (USD deposits, 54.4 14.3% trn)

Equities, investments, 32.8%

Other total, 3.2% Insurance and pension reserves, 28.1%

Investment Bonds, 7.0% trusts, 7.2%

Euro area (USD 25.1 trn)

Cash & deposits, 35.8%

Other total, 3.9% Insurance and Equities, pension investments, reserves, 14.3% 31.7%

11

0%

10% 20% 30% 40% 50% 60% 70% 80% 90% 100%
62

Note: Data after 2009 includes Personal Equity Plan. Source: Nomura, based on Financial Services Agency

Note: Data for Japan and the US as of end-Dec 2012; data for Europe as of end-Sep 2012. Source: Nomura, based on BOJ

When the current growth strategy is a success, government debt outlook should stabilize

Government Outlook for Outstanding Debt Assumption of Growth Strategy Scenario: The average annual growth rate for the FY2011FY2020 period is projected to reach approximately 3% in nominal and 2% in real terms. The rate for change in the Consumer Price Index is projected to turn positive in FY2012, and to stay as high as around 2% over the medium to long term. Assumption of Prudent Scenario: The average annual growth rate for the FY2011FY2020 period is projected to reach mid-1% in nominal and over 1% in real terms. The rate of change in the Consumer Price Index is projected to turn positive in FY2012, and to stay as high as around 1% over the medium to long term.
(% of nominal GDP) 250 Actual 225 Prudent Scenario Growth Strategy Scenario 200

175

150

125

100 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 18 19 20 21 22 23 (FY)
Source: Nomura, based on Cabinet Office

63

Employed persons can increase by 2.04 million if womens employment rate rises to potential employment rate

Womans employment rate and potential labor force rate

95% 90% 85% 80% 75% 70% 65% 60% Woman's potential labor force rate 55% Woman's employment rate in 2012 50% 20 24 2529 3034 35 39 40 44 45 49 50 54 55 59
Source: Nomura, based on Ministry of Internal Affairs and Communications

86.7

Employed persons would be boosted by 2.04 million in 5 years (current total employed = 54.86 million)
79.0 80.9 78.9 82.5 78.2

78.0

77.6 71.7 68.7 68.6 67.7

75.7 73.4 68.0

64.6

(age)
64

Japan recommended stocks

Japanese stocks in our Global Recommended List

Sector Staples Industrials Tech Materials Industrials Discretionary Financials Financials Financials Financials

Code 3382 6326 6501 6988 7013 7203 8306 8316 8591 8801

Name Seven & I Kubota Hitachi Nitto Denko IHI Toyota Motor MUFG SMFG Orix Corp Mitsui Fudosan

Share Nomura price Rating (14 Jun) (14 Jun) (yen) Buy 3,360 Buy 1,468 Buy 643 Buy 5,660 Buy 344 Buy 5,590 Buy 567 Buy 3,990 Buy 1,257 Buy 2,747

P/E (x) 17.0 17.7 13.2 12.4 17.7 11.1 10.4 12.5 9.2 37.1

Recurring profit growth estimate This FY Next FY (%) (%) 16.6 10.0 42.0 17.0 33.5 21.7 57.3 10.8 31.1 13.7 65.0 7.0 2.0 3.1 -32.6 -6.6 31.6 23.8 7.3 6.8

ROE (%) 8.8 13.1 10.8 14.5 10.2 12.6 7.3 7.4 8.7 5.4

P/B (x) 1.57 2.43 1.49 1.91 1.75 1.46 0.71 0.85 0.93 2.04

Note: (1) P/E, ROE, and dividend yield based on estimates for next FY in case of companies with less than three months before their FY-end and on estimates for current FY for companies with three months or longer before their FY-end. (2) P/B ratios are based on most recently announced fiscal year-end BPS, calculated with shares outstanding (ie, issued shares less treasury stock). (3) Data are based on US GAAP when available and on Japanese accounting standards otherwise. In addition, data are consolidated when available and parent when consolidated data are not available. Recurring profit figures for US GAAP- and IFRS-reporting companies are based on their pretax profit figures. (6) Share prices, earnings forecasts, and ratings as at 14 June 2013. Source: Nomura

65

Investment Themes: Rates

Market forecast
(%) Latest 7-Jun Japan Basic loan rate Unsecured O/N call 3M Tibor 2yr JGB 5yr JGB 10yr JGB 20yr JGB 30yr JGB USD/JPY EUR/JPY Nikkei 225 (K)
Source: Nomura

2013 June 0.30 0.08 0.22 0.13 0.33 0.80 1.60 1.75 98 127 13.5 September 0.30 0.08 0.20 0.11 0.25 0.70 1.55 1.70 98 127 13.5 December 0.30 0.08 0.20 0.11 0.25 0.70 1.55 1.70 100 128 14.0 0.30 0.08 0.20 0.13 0.33 0.80 1.70 1.90 103 130 14.5 March 0.30 0.08 0.20 0.15 0.43 0.95 1.80 2.00 105 132 15.5

2014 June September 0.30 0.08 0.20 0.15 0.43 0.95 1.80 2.00 105 132 15.5

0.30 0.08 0.23 0.13 0.28 0.84 1.66 1.80 97.56 128.96 12.88

0.00 0.20 0.10 0.23 0.60 1.45 1.60 94 123 12.0

~ ~ ~ ~ ~ ~ ~ ~ ~ ~

0.10 0.23 0.16 0.50 1.00 1.80 1.95 105 135 15.0

0.00 0.18 0.10 0.20 0.60 1.45 1.60 94 123 12.0

~ ~ ~ ~ ~ ~ ~ ~ ~ ~

0.10 0.23 0.16 0.45 0.95 1.80 1.95 105 135 15.0

0.00 0.18 0.10 0.20 0.60 1.45 1.60 94 123 13.0

~ ~ ~ ~ ~ ~ ~ ~ ~ ~

0.10 0.23 0.16 0.45 0.95 1.80 1.95 105 135 16.0

0.00 0.18 0.10 0.20 0.60 1.45 1.50 96 125 13.0

~ ~ ~ ~ ~ ~ ~ ~ ~ ~

0.10 0.23 0.18 0.55 1.10 1.95 2.15 106 135 16.0

0.00 0.18 0.11 0.25 0.65 1.50 1.70 98 125 14.0

~ ~ ~ ~ ~ ~ ~ ~ ~ ~

0.10 0.23 0.20 0.60 1.20 2.05 2.25 110 138 16.5

0.00 0.18 0.11 0.25 0.65 1.50 1.70 98 125 14.0

~ ~ ~ ~ ~ ~ ~ ~ ~ ~

0.10 0.23 0.20 0.60 1.20 2.05 2.25 110 138 16.5

- We expect 10yr yields to trade at around 0.80% at end-June and 0.70% at end-December. We expect the next major market downturn to take place sometime in January-March 2014. - We expect 10yr UST yields to trade in a 1.8-2.2% range at end-June and trade in a 1.8-2.2% at end-December. - As the amount of JGB purchases by the BOJ is set to exceed the national budget deficit, JGB supply and demand should tighten if investors simply replace redeemed bonds. - The BOJ is unlikely to increase JGB purchases further. It could increase equity purchases if conditions warrant. We think the Japanese government will devise a supplementary budget after the July upper house election. - Fed officials will likely tone down their language on an early QE3 exit toward summer.

- As US rates rise, major domestic investors and retail investors (via toshin) could shift funds out of JGBs.
-Weaker JPY could cause investor selling of super-long JGBs that exceeds BOJ purchases.
67

Key issues

BOJ: Market stabilization measures, policy duration, further easing

options
Government: Stimulus measures, fiscal reform, consumption tax hike Investors: Domestic accounts reducing yen bond exposure, their

alternative investment options, foreign investor trends

Money flow: A decline in current account surplus and capital flight,

bank deposit-loan balance, retail investors toshin flow

US and eurozone economies: Monetary easing (exit), Japanization of

euro area and US markets

68

Summary of short-term views

Short-term views (to September 2013)

- 10yr yields expected to trade in a 0.60-1.00% range 0.80% at end-June; 0.70% at endSeptember. - The market should bottom at 10yr yields of 1.0% within the year. We expect bull flattening in July-September. - Expectations for the governments growth strategy should play out after the July upper house election. The government is unlikely to postpone the implementation of a consumption tax hike; instead, we think it will make a supplementary budget its campaign pledge. It may discuss the resumption of nuclear power generation. - The announcement effect of BOJ policy should gradually decline and BOJ-driven supply/demand improvements gradually take hold. Expectations for higher risk asset purchases should heighten ahead of the October meeting, as the Bank is likely to revise its forecasts in its Outlook Report, which could lead to a JGB sell-off. -- Rates upside risks: Increase in the BOJs equity purchases; Japans widening trade deficits, large retail flows out of bank deposits into investment trusts; earlier talk of a Fed QE3 exit; ECB purchases of peripheral government bonds.

- Rates downside risks: BOJ extension to longer-dated funds in its signal operations, BOJ rate cut; Chinas early shift to monetary tightening, and an economic hard landing.

69

Summary of long-term views

Long-term views

(from end-2013; accelerated growth, end to monetary easing)

- Weak yen should encourage investor and corporate funds to shift into foreign markets; yen rates to trade in higher ranges as deflationary pressures decrease. - Retirement of baby-boomers helps companies reduce payrolls (2012~); wage deflation eases. However, we expect CPI inflation to remain in a 0.5-1.0% range, with the BOJ missing its 2.0% inflation target. - A consumption tax hike from April 2014; decrease in bank deposits and increase in public pension funds to create flattening pressure; ahead of a consumption tax hike, last-minute purchases should boost spending in H2 2013.

- UST rates back up as the Fed exits QE3. Major banks incur valuation losses on foreign bonds
and reduce exposure to yen bonds. - BOJ should begin to decrease JGB purchases in January-March 2016. - Rates downside risks: Downshift in growth expectations; slowing corporate capital spending. - Rates upside risks: Japanese governments greater reliance on a weak-yen policy; decrease in the current account surplus; increase in capital flight.
70

Recommended investments

Short term (to September 2013)

- Long 5s (at 0.40%, target of 0.25-0.30%) - Long 10s (at 0.90%, target of 0.65%)

- Long 20s (at 1.75%, target of 1.50%)

- Long 20yr Asset Swaps (at 0bp, target of -10bp)

Long term (from end-2013; assuming accelerated growth and end to monetary easing)

Short 20s (at 1.50%, target of 1.80%); caution needed in timing the entry due to negative carry. 5s20s steepener (at 125-130bp, target of 145bp); caution needed in timing the entry due to negative carry.

71

Is inflation target a downside or upside factor for JGB rates?

10yr forward rates vs. 10yr JGB yields
10yr JGB yields (%) 4.00
10yrf 1m 5yrf 1m (%) 6

5yr and 10yr forward rates

3.50 3.00

2.50 2.00 1.50

2 3

1.00 0.50 0.00 0.00 1.00 2.00 3.00 4.00 5.00

0 1996 1998 2000 2002 2004 2006 2008 2010 2012 1

5yr1m swaps rate

Source: Bloomberg, Nomura Securities Co., Ltd. Source: Bloomberg, Nomura Securities Co., Ltd.

If the market factors in a 2% inflation rate, 1% real growth, and 2.5% short-term rates in five years, 10yr JGB yields should be trading slightly below 2.0%.

Assuming that the BOJ fails to achieve its inflation target within two years and continues with JGB purchases for a sustained period, interest rates should be kept down.
72

Rates continue to sell off despite improved supply and demand due BOJ purchases
10yr JGB yields and 10yr OIS rates
(%) 1.6 [a] less [b] 10yr JGB yields (RHS) [a] 10yr JPY OIS [b] (%) 0.5
(%) 4.5

10yr UST yields and 10yr OIS rates

(%) [a] less [b] 10yr UST yields (RHS) [a] 10yr USD OIS [b]
0.5

1.4

0.4

4 0.4

1.2 0.3 1
0.2

3.5

0.3

0.8 0.1 0.6

2.5

0.2

0.4

0.1 1.5

0.2

-0.1

Source: Bloomberg

As BOJ purchases brought the JGB-OIS spreads close to zero, JGB rates would be unlikely to decline further on improved supply and demand conditions. The rates backup since the QQE adoption was not caused by the widening of JGB-OIS spreads, but rather by a rise in OIS rates.

When 10yr OIS rates were above 1.0% in Japan, those in the US were at 3.5%. A QE3 exit alone should not be enough to cause 10yr JGB yields to trade consistently above 1.0%.

73

Risk of a sharp JGB sell-off under Abenomics

Pattern 1: Bank selling Shortened BOJ policy duration causes banks to shed existing holdings and duration (similar to the 2003 sell-off). The markets confidence in the BOJ achieving the 2% inflation target could cause a sharp JGB sell-off. Pattern 2: Current account and capital account balances deteriorate further If the trade balance remains in deficit for a sustained period, foreign currency assets should increasingly be cashed out, thus bringing the capital account into deficit. Companies entry into overseas markets would worsen the trade account and increase the capital outflow. Industrial activity would be hollowed out more (similar to US in 1985-1995). Pattern 3: Abenomics fails Corporate bankruptcies could increase, entailing large bad debts at banks. Corporate and bank credits would be the first to face problems, rather than JGBs. Banks funding problems and their reduced risk tolerance could lead to bear flattening (as in 1998).

74

Investment themes: FX

Summary
The BOJs impact on the JGB market: The BOJ is going to purchase about 70% of monthly JGB issuance. The share of the BOJ in total JGB outstanding is expected to rise to 20% from 12% currently.

The direct impact through portfolio rebalancing: Households own less than 3% of JGBs, so institutional investors (Banks: 38%, Insurance: 19%, and Pensions: 10%) must move. Insurance companies are buyers of the super long zone, while banks trade at the shorter end. Pensions are investing more broadly.
The FX impact from portfolio rebalancing: The FX impact may be smaller than expected. Banks: Fund in local currencies when investing in foreign bonds. Pensions: Contrarians can be forced to change reference portfolios, but can still be dip buyers. Lifers: Most natural alternative investment is hedged basis foreign bonds. Indirect impact through risk appetite channel: More important for FX. Retail investors: Sentiment is clearly improving. Confidence indicators are at their highest levels in 10 years. The BOJs most recent policy announcements should improve risk appetite further 30%:BRL, TRY:20%, MXN:10%, ZAR:10%, RUB:10%? Lifers: A lower hedge ratio is more likely for high yield currencies: AUD in G10 Major government bond index: MXN, PLN, ZAR The impact on fixed income: Lifers may still prefer core, semi-core eurozone bonds (France and the Netherlands). UST investment will likely shift to the longer end to increase carry. US mortgage and EM bonds (MXN, PLN, AUD) are also likely targets, in our view.
76

FX: Looks like yen appreciation trend has ended

JPY shifting to cheaper and cheaper. Exporters should benefit.
Historical Forex trend (USD/JPY)
(USD/JPY) 400

350

300

250

200

150

100

50

0 1971

73

75

77

79

81

83

85

87

89

91

93

95

97

99

2001

03

05

07

09

11

13 (FY)

Note: Exchange rates are as recorded on Tokyo forex market Source: Nomura, based on BOJ data

77

FX: Money flow is structurally supporting JPY decline

Trade balance has shifted from surplus to deficit since 2011
Trade Balance & Current Account Balance
trillion yen

Trade Balance
(as % of nominal GDP) Current Account Balance

20

40

Trade balance

Trade balance (ex. fossil fuels)

15

30

Fossil fuels

10

20

10

-10
-5
Trade Balance

-20
-10

-30
-15 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 E E E
CY

-40
88 90 92 94 96 98 00 02 04 06 08 10

(CY)

12
78

Note: Nomura estimates CY13 toCY15 Source : Nomura, based on Trade Statics of Japan

Source : Nomura, based on Trade Statics of Japan

FX: Relatively more monetary easing has meant depreciation of JPY

BOJ is getting more dovish than the Fed
Monetary base ratio of US/Japan, and the USD/JPY rate
(end 1989 = 100)

160 150 140

110 100 90 80 70 60 50 40 USD/JPY(lhs) US/Japan monetary base ratio(rhs) 30 20 10 0 90 92 94 96 98 00 02 04 06 08 10 12 14

79

130
120 110 100

90
80 70 60

US/Japan monetary base ratio forecast(rhs)

Source: Nomura, based on Bloomberg and Bank of Japan

Disclosure Appendix A1
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We, Yunosuke Ikeda, Tomo Kinoshita, Naka Matsuzawa, Hiromichi Tamura and Kevin Gaynor, hereby certify (1) that the views expressed in this report accurately reflect my personal views about any or all of the subject securities or issuers referred to in this report, (2) no part of my compensation was, is or will be directly or indirectly related to the specific recommendations or views expressed in this report and (3) no part of my compensation is tied to any specific investment banking transactions performed by Nomura Securities International, Inc., Nomura International plc or any other Nomura Group company.

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