Growing challenges to bank returns during the pandemic have weighed on recovery hopes for value stocks. But our research of Japan’s experience and global value trends suggests value stocks don’t necessarily need financials to turn the corner.

Value stocks continue to struggle through the coronavirus crisis. The MSCI World Value Index fell 15.7%, in US dollar terms in the year through July 31, underperforming the MSCI World, which was down 1.3% over the same period. Financials, which comprise about one-fifth of the global value benchmark, were down 21.9%.

Banks face a long list of challenges. Perpetually low interest rates are compressing net interest margins. Loan volumes are falling, and bad debts are rising. In this environment, it will be tough for banks to outperform. And if banks are stuck in the mud, the outlook for value stocks looks questionable.

But is that assumption true? Not necessarily. While many investors associate banks with value stocks, our research suggests that value stocks can do well without relying on banks as the engine for recovery.

Japan’s No-Bank Value Market

Japan provides a good case study for a different kind of value market. In the Japanese market, financials have underperformed the broader stock market since 1998 (Display, left). Yet over the same period, value stocks have outperformed the market. That’s counterintuitive to many value investors.

At the time, Japanese bond yields had fallen to historic lows. In 1998, the 10-year Japanese government bond yield slipped below 2%, where it stayed for most of the next two decades. Similarly, in 2019, the US 10-year Treasury fell below the 2% threshold and is now widely expected to remain very low for a prolonged period as the Fed battles the macroeconomic effects of the pandemic with loose monetary policy.

In Japan’s ultralow rate environment, banks were indeed handicapped. Since 1998, Japanese banks underperformed sharply, while Japanese insurance companies did well and performed in line with the broader market (Display above, right). With banks around the world likely to face similar challenges today, we think the Japanese experience could be more relevant for global value investors than in the past when the country was widely seen as a macroeconomic outlier.

Maybe Japan is different? It’s well known that Japan’s demographics are shaped by an aging population, while its economy and labor market are less flexible than developed peers. And Japan’s banks—which account for about 16% of the country’s value index—historically haven’t written down bad debts as much as US and Western European lenders have. So while the Japanese case is instructive, we also took a closer look at the role of financials in global value performance over the years.