Portfolio Manager Commentary

Overview, strategy, and outlook: As of May 31, 2014

Asia reverse roadshow: Update on Japanese banks

Last month, we traveled to Tokyo to meet with several issuers, including Sumitomo Mitsui Banking Corp., Sumitomo Mitsui Trust Bank, Mitsubishi UFJ Trust and Banking Corp., and Mizuho Financial Group. We also had the opportunity to meet with Fitch Japan, Standard & Poor’s Japan, and Moody’s Japan to discuss the Japanese banking sector. With over $230 billion of commercial paper (CP), Yankee certificates of deposit (CDs), and asset-backed commercial paper1 representing more than 10% of all prime money market instruments outstanding, the Japanese banking sector has become increasingly important to us as an investment alternative. While Japan’s recent economic history is frequently characterized as The Lost Decade, the consensus is that Abenomics and the Bank of Japan’s (BOJ’s) monetary easing have boosted expectations for higher growth and an end to deflation and have improved the operating environment for banks. Of course, it has also weakened the yen and has resulted in a sharp appreciation in the Japanese equity market. The latter has flowed through to earnings via realized gains on stocks as well as increased fee income from the sale of investment trust products. However, banks and the rating agencies noted that there are risks if the government’s policies—specifically the third arrow related to structural reforms—do not increase Japan’s growth rate or if Japanese government bond (JGB) yields rise significantly. A loss of confidence in either Abenomics or the BOJ’s commitment to monetary easing would likely lead to a sharp decline in the Japanese equity market, presenting a significant challenge to profitability in the banking sector.

Japan’s real gross domestic product is forecast to expand a bit above trend and potential in fiscal year 2014 and 2015, supporting modest demand for domestic loans. It is uncertain how much of this recent but accelerating loan growth is due to temporary fiscal stimulus and front-loaded household consumption, ahead of the rise in the consumption tax from 5% to 8% that took effect on April 1, 2014. The rating agencies noted that there is still little indication that private-sector corporations have begun a new capital expenditures cycle and, overall, Japanese corporations remain net cash positive.

As some of the recent one-off benefits of Abenomics normalize, the recent positive earnings dynamics cannot be sustained without a pickup in domestic lending profitability, but virtually all parties see continued margin pressure. However, overseas business lending is expected to increase further, particularly in Asia, while nonorganic growth will also likely continue. In order to fully realize the added benefits of geographic diversification while reducing exposure to a weak domestic lending market, this expansion must be properly managed.

Asset quality has been and continues to be very strong because Japanese companies remain only modestly levered and Abenomics has further improved domestic economic conditions. Nonperforming loans and impairment losses are at recent historically low levels. In the most recent fiscal year that ended March 31, 2014, all of the five major banks had net reversal of credit costs as banks reported that many borrowers were rerated, leading to lower expected credit losses. And while these loss levels are expected to normalize from abnormally low levels in 2014 and 2015, asset quality should remain steady.

In conjunction with BOJ monetary easing and balance sheet expansion, the megabanks decreased their holdings of JGBs in 2013. This move, when coupled with low durations of JGB portfolios, should leave the banks in a better position to absorb the impact of a spike in interest rates. Still, a sharp rise in bond yields could result in a reduction in regulatory capital ratios.

In recent years, the megabanks have done a good job in reducing domestic stock, which has had a beneficial impact on balance sheets. Historically, these holdings have sometimes been a source of volatility in income and capital position but are near the limit for further sell-offs given the necessary level of strategic stock holdings focused on business relationships. Due to a combination of equity raisings, earnings retention, and improvement in unrealized gains/losses on investment securities, capital buffers have been increasing since the global financial crisis. While regulatory capital levels among Japanese banks, especially Tier 1 capital ratios, now compare favorably with many international peers, growing expectations for higher dividends coupled with overseas expansion plans may slow further material strengthening of capital buffers.

Liquidity remains ample for the megabanks, with a loan-to-deposit ratio around 70%; low dependence on confidence-sensitive market funding; ample balance sheet cash; and a high proportion of JGB holdings, which historically represent a reliable source of alternative liquidity in times of stress. Still, foreign currency funding remains an important means of addressing any funding gap from deposits. Notably, some of the banks reported that a high percentage of the proceeds from issuing U.S. CP and CDs are deposited at the U.S. Federal Reserve, where they earn the 25 basis points (bps; 100 bps equals 1.00%) interest on excess reserve (IOER) rate. By paying less than 25 bps on their CP and CDs, the banks have been able to earn a small but consistently positive spread over the IOER.

Reported profits for the fiscal year that ended March 31, 2014, were at or near record levels for each Japanese banking group. This was due to the aforementioned combination of falling net credit costs, a favorable market environment for the banks’ investment portfolios, stronger fee income from financial product sales, and expansion of overseas businesses. On the other hand, core banking profitability is expected to remain low due to severe competition among banks with abundant liquidity, limited sustained growth in private credit, and persistently low interest rates. Net interest margin has been steadily decreasing and is well below 1% due, in large part, to declining loan yields. We believe this is not a cause for concern since, in general, net interest margin in Japan tends to be lower than that for banks in other major geographic areas. Despite headwinds from higher credit costs and lower domestic equity gains, profitability should remain satisfactory over the next 12 to 18 months due to higher-than-average economic growth. Still, each banking group is forecasting lower net profits for the fiscal year ending March 31, 2015.

In all, our trip to Japan was very informative, productive, and beneficial. We take comfort from the Japanese megabanks’ strong liquidity, current excellent asset quality, improved capital levels, record net profits, strong systemic support assumptions, and improved operating environment. Despite some specific credit concerns, the trip helped confirm our conviction that investing in the Japanese banking sector is consistent with minimal credit risk.

Rates for sample investment instruments
Current month-end % (May 2014)

Sector

1 day

1 week

1 month

2 month

3 month

6 month

12 month

U.S. Treasury repurchase agreements (repos)

0.07

0.07

0.06

0.06

U.S. Treasury bills

0.02

0.03

0.04

0.08

Agency discount notes

0.03

0.03

0.04

0.04

0.05

0.07

0.11

LIBOR

0.09

0.12

0.15

0.19

0.23

0.32

0.53

Asset-backed commercial paper—First Tier

0.13

0.13

0.15

0.18

0.21

Dealer commercial paper—First Tier

0.11

0.12

0.15

0.17

0.18

0.27

Municipals—First Tier

0.07

0.06

0.08

0.08

0.09

0.12

0.15

Sources: Bloomberg L.P. and Wells Capital Management
Past performance is no guarantee of future results.

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1. As of March 31, 2014

A portion of the municipal money market fund’s income may be subject to federal, state, and/or local income taxes or the Alternative Minimum Tax (AMT). Any capital gains distributions may be taxable. For the government money market funds, the U.S. government guarantee applies to certain underlying securities and not to shares of the fund.

The views expressed and any forward-looking statements are as of 5-31-14 and are those of the fund managers and the Money Market team at Wells Capital Management, subadvisor to the Wells Fargo Advantage Money Market Funds, and Wells Fargo Funds Management, LLC. Discussions of individual securities, or the markets generally, or any Wells Fargo Advantage Fund are not intended as individual recommendations. Future events or results may vary significantly from those expressed in any forward-looking statements; the views expressed are subject to change at any time in response to changing circumstances in the market. Wells Fargo Funds Management, LLC, disclaims any obligation to publicly update or revise any views expressed or forward-looking statements.

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