Our Global Investment Committee always seems to meet in the middle of great volatility, and this time was no exception, with the investment world facing all sorts of new challenges. However, in our December 11th, we weighed all these new factors and updated our house view on the global economic backdrop, financial markets and investment strategy advice.
Looking back, the 3Q sluggishness of the Japanese and European economies was greater than we anticipated and the plunge in oil prices certainly surprised us (along with nearly everyone else), but global equities did have positive returns, even in USD terms, since our last meeting, and greatly outperformed global bonds. Looking forward, we remain reasonably positive on the global economy and developed market equities, with only mild enthusiasm for US equities, but particularly strong enthusiasm for Japanese equities. There certainly are some worrisome issues, as always, but we find none of them convincing enough to halt the upward momentum in economic growth or risk asset prices. In particular, a Fed hike in June or July will not elevate US 10-year yields much, in our view, especially as inflation (including the long-term expectations for such) are low due to oil prices. Meanwhile, non-US bonds and forex markets have already nearly fully priced in moderate Fed hikes in the 2H15. Interestingly, due to a G-3 and China economic rebound, among other factors, we make a rather bold prediction that commodity prices will be higher by end-March and through 2015. The main risks to these views are political in nature, with Greece, Russia/Ukraine, and vulnerable emerging markets topping the list, although the credit markets also bear close watching for contagion effects from energy sector problems.
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 GDP will closely match economists' consensus forecasts growth going forward, with the US remaining very firm and the Eurozone and Japan recovering steadily in the 1H15 (with the 4Q14 quite positive, as well). However, if G-3 economies actually match these forecasts, which predict rather decent growth for Japan and the Eurozone, we believe that investors will be positively surprised, as there are so many skeptics about these two regions at present.
Firstly, the US economy continues to be very firm and we agree that it will continue at the consensus rate of 2.8%-3.0% HoH SAAR for the 1H15 (and in the 2H15, as well), with consumer spending, capital expenditure and housing construction leading the way. As for employment, we continue to believe that payrolls will expand at a healthy rate, and that the unemployment rate should gradually decline further in 2015. Meanwhile, wages should begin to rise at a faster rate, which should support consumer spending, especially in real terms as declining gasoline prices provide a strong windfall. This will likely lead to stronger housing demand and higher housing prices, thereby reinforcing the wealth effect. Along with other firm macro-data, this will confirm the Fed's removal of monetary accommodation at a moderate pace.
Japan's economy continued to decline in the 3Q14, which was much worse than we, or consensus, expected. The major problem is that wages have not grown to match inflation and the VAT hike. Inventories have also continued to decline and capex has been surprisingly slow (partly due to the VAT hike, as well). However, as the “VAT shock” wears off and wages rise (bolstered by a newly re-elected Prime Minister determined to push companies for such), the economy should finally start recovering in the 4Q14 and onwards. We forecast a 2.4% to 2.6% HoH SAAR growth rate in the 1H15 and a 1.6%-1.8% HoH SAAR rate in the 2H15, led by inventories, personal consumption and capex. Lower energy costs also should provide a strong boost for the economy, especially at natural gas imports are also based upon oil prices. As for inflation, the CPI is losing momentum due to oil prices, but the weaker Yen will help this issue, especially when looking at CPI ex food and energy. Also critical in this regard is the housing rent factor. As long stated in our reports, core inflation cannot rise sufficiently without rent increases.
In the Eurozone, conditions also continued to be weaker in the 3Q than we or consensus expected, substantially due to the effects of the sanctions related to the Ukrainian crisis, but the economy should improve going forward, greatly due to declining price of oil, of which Europe is a large net importer. We forecast GDP at 1.2% to 1.4% HoH SAAR in the 1H15 and 1.7%-1.9% in the 2H14. The weakness of the EUR and some improvement in credit conditions should help significantly, especially given ECB incentives to banks for small-business loans. Meanwhile, the CPI rate should decline to nearly 0% YoY in the coming months. Although it is not the benchmark for the ECB, we believe that core inflation will receive much more attention in the coming months, and at 0.7% should alleviate some deflation concerns. We do keep in mind, however, that underneath the surface, the entire system remains quite fragile, so we will watch developments very closely. In particular, the Greek Presidential election is important (although we believe the politicians and their voters will avert chaos), as is whether civil unrest will accelerate again in Europe's periphery. Finally, geopolitical conditions are clearly important, but we continue to believe that the Ukraine situation will remain essentially a stalemate, with neither side wishing to push much further.