2015 Q2 House Views Update
by Nikko Asset Management's Global Investment Committee

Introduction

Nikko AM's Global Investment Committee met on June 24th and updated our house view on the global economic backdrop, financial markets and investment strategy advice. As always, there are some worrisome issues, including Greece, but we find none of them convincing enough to prevent moderate increases in equity prices. In particular, our prediction of the Fed hiking faster than consensus (although still in a gradual manner) will likely cause some volatility, it should prove no more problematic than the tapering process, which readers will likely recall many strategists proclaiming would cause a crisis. Indeed, global equities rose sharply during the tapering process because the economy was relatively firm, with low inflation, and corporate earnings continued to grow. We expect much the same in this case, but we continue to look only for moderate equity gains in the year ahead, with valuations remaining relatively steady.

The Global Economic Backdrop
(note that all dates in this report are Calendar Year (CY)-based and growth numbers are seasonally adjusted annual rates (SAAR) unless otherwise specified)

In our view, the G-3 economies will match the current consensus in the next few quarters. In particular, the US should continue to rebound from the unusually brutal winter and the West Coast port strike. The Eurozone and Japan should recover nicely too, although Japan's 2Q GDP QoQ rate should slow from its rapid 1Q pace. China's economy should also match consensus, although there certainly are several large and well-renowned tail risks there.

The US economy certainly has mixed conditions, but consumer spending in real terms has clearly recovered from a weak 1Q, and we believe that such will continue very firm. GDP should grow 2.7% HoH SAAR in the 2H15 (and the following two quarters, as well), with consumer spending and housing construction continuing to lead the way. Capex and net exports should remain soft, however. As for employment, we continue to believe that payrolls will expand at a healthy rate, especially in the housing construction and related services areas, and that the unemployment rate will continue to decline. As for wages, we still believe that the official monthly data, despite some recent acceleration, is likely understating growth. With numerous strikes and most major retailers hiking wages quite sharply, this should easily offset any weakness in energy industry- related wages.

We have been watching US auto sales very closely, and they rebounded to post-2008 highs recently after a weak winter period. We continue to expect very firm sales, and investors should watch future sales closely. Retail spending is soft on a nominal basis due to low gasoline prices, but are strong on a “real” (inflation adjusted) basis. New home sales continue to rebound and permits for new home construction are very strong, but durable goods orders remain sluggish. In particular, aircraft orders have weakened as customers are likely cancelling prior orders as fuel efficiency does not need to be improved (due to low fuel costs) and many countries and customers, especially in MENA and emerging markets are cutting expansions. As for other durable goods, orders for the energy and agriculture industries remain weak, as well, and will likely continue to be so.

Japan's economy rebounded in the 1Q, although mostly driven by inventories. We still believe that inventories can add slightly further to GDP growth in the 2Q and thereafter, leading to our forecast of 1.5% HoH SAAR growth in the 2H15 and 1H16, basically close to consensus. Personal spending should continue firm as “real” wage growth is very high now, especially due to recent wage negotiations. The wealth effect and increased confidence should also support spending (and perhaps housing construction, as well). Capex and government spending should grow slightly, but there is uncertainty about the level of the contribution from external trade. As for inflation, the CPI should be below 0.8% YoY in the 4Q, as while the weaker Yen helps matters, declining gasoline prices should prevent the BOJ from attaining its 2% core CPI goal this year. Once again, it is key to watch if the CPI housing rent component starts rising.

In the Eurozone, conditions continue to improve quite broadly, and we forecast GDP growth at 1.9% HoH SAAR in the 2H15 and 1H16. The weakness of the EUR and some improvement in credit conditions should help significantly. Lower oil prices kept inflation low, but it is now out of deflation (note that core inflation never went negative). Even property prices continue to rise, which adds to the wealth effect and to increased housing capex in many countries. We do keep in mind, however, that underneath the surface, the entire system remains quite fragile. We still believe that Greece will avoid leaving the Eurozone, although it is clearly a large tail risk and may require a change in government or key figures. Clearly, geopolitical conditions are also key, but we continue to believe that the Ukraine situation will remain essentially a stalemate, with neither side wishing to push much further.

China's economy continues to struggle during its transition to a more balanced economy, but does not appear to be in a hard landing. We expect it to achieve 6.6% HoH SAAR growth in the 2H15 and 1H16, quite similar to consensus. Inflation remains very low, as measured by the CPI, and pipeline inflation remains negative. Exports are subdued, while imports in value terms are suppressed mostly by lower commodity prices. Housing starts are declining rapidly, so construction will likely subtract from the economy this year, but housing sales have greatly firmed. Top tier cities' property prices are quite firm, but middle to lower tier cities' prices remain quite weak due to large oversupply. Interestingly, auto sales have softened recently, with some analysts suggesting that this is due to consumers wishing to invest in the stock market rather than consume. It could, however, actually be a sign of slowing consumption, so we will have to monitor such carefully.

The government is acting rapidly to counter the deceleration in certain parts of the economy. Besides encouraging a stock market boom, in order to counter the negative effects of some previous declines in housing prices, it has increased infrastructure spending and loosened rules for the property market and local government financing. Importantly, it has also established a new municipal bond market, in which banks are encouraged to buy bonds at low interest rates instead of lending to local governments. We still expect further government reforms to continue to excite equity investors in the coming quarters.

Lastly, industrial production will continue to be constrained so as to reduce pollution and we continue to expect (as we have for several years) that huge efforts will be made, even beyond current optimistic projections, on solving this problem, which will provide many good investment opportunities for global providers of pollution control equipment of all kinds.

Other Emerging economies have continued reasonably stable in the past quarter, although Brazil is struggling. A strong USD due to a Fed determined to normalize and softness in commodity prices have, however, been major headwinds. Given our view of stronger G-3 and Chinese growth, we remain reasonably enthusiastic about EM economies overall, although we think oil prices will decline slightly due to increased global supplies, especially from Iran, but other commodity prices should remain flat overall.

In sum, we believe the global economy should be quite firm for the next year, but not so strong as to cause inflation concerns.