2015 Q1 House Views Update
by Nikko Asset Management's Global Investment Committee

Central Banks

Sentiment about Fed policy remains very volatile, and we are shifting our stance on the first hike from June/July to the 4Q. Despite firm economic growth, we believe that a negative YoY CPI through September will steady the Fed's hand. The FOMC roster includes more doves this year and the core Fed leadership is traditionally quite dovish, so we expect the Fed funds channel rate at only 0.50-0.75% at year-end. We don't have a strong degree of certainty about this change in our Fed stance, however, as several important FOMC members have said they do not care about inflation and wish to normalize rates at least to some degree in the near future.

As for US inflation, we expect the CPI to remain negative YoY for the following reasons:

  1. continued US oil production and an Iranian deal will keep oil prices from rising. This not only affects consumers' gasoline expenditures but also that for the entire transportation system, which is a significant portion of corporate costs;
  2. medical costs have also sharply decelerated due to “Obamacare”;
  3. shelter prices are still increasing but statistical methods for quality improvements (especially in telecommunication services, consumer elections and autos) will keep downward pressure on prices.

In sum, we estimate that the CPI will remain in the -0.1% to -0.4% YoY range through September. Similarly, core inflation should remain subdued, at the 1.6%-1.7% YoY rate this year.

In Japan, oil's weakness has decreased the prospects of inflation, but there is less political pressure for the BOJ to ease policy further soon, although there is some chance it might do so in the 4Q15. There has been only limited criticism by the G-20 of the weaker Yen, but such could accelerate if it weakens much further, and Japan does not likely want the Yen to become too weak. The economy should improve, so there will be less justification to ease policy for domestic growth reasons, which is what the G-3 central banks have agreed upon as acceptable. The official Core CPI (ex-VAT), which includes energy, is slightly above zero (due to the weak Yen) and when one excludes energy, it was flat on a 6-month SAAR basis in January.

Rent is a significant part of core inflation and it continues to be soft. Indeed, unless rent starts to rise, it will be very difficult to hit the core target on a structural basis. Also, it is likely that the 2% target was made for psychological effect (to boost reflationary behaviour) and that the BOJ is secretly happy with 1.5%, which, to be honest, seems a more appropriate target to us.

Despite a mixed consensus (both within Nikko AM and in the markets) until late-January, the ECB conducted sovereign bond QE in February, as we predicted back in September, but it was very bold and very large. The program has already succeeded in most ways and it will be difficult for the ECB to implement the program through September 2016, but it is safe to say that we expect no other ECB measures in the coming year. The rhetoric, however, will sound increasing neutral as the ECB declares how successful it has been.

Consumer inflation should be very close to zero through the 3Q15 due to low energy prices, but there is upward pressure from

  1. rising housing rents;
  2. less discounting by retailers and most importantly,
  3. the effect of the weak EUR on goods imported from outside the Eurozone.

Thereafter, the CPI should be over 1% in the 1Q16 and near 2% by late 2016. The tail risk is, of course, Greece, but due to our view that Greece will relent on reforms, we do not believe the ECB will have to react. Voters in other European nations will also be chastened by Greece's failure to stop reform and austerity, but the improvement in economic growth and employment (that we predict) should be the greatest factor in reducing anti-Eurozone sentiment.

As for the BoE, inflation is low, but the economy should rebound, so we currently expect a 1Q16 rate hike. There is a chance, however, that this might not occur if there is too much political instability resulting from the upcoming election that ends up affecting economic growth. On the other hand, if Sterling was to fall very sharply and the UK were to basically move into crisis mode then the BOE may actually need to raise rates to support the currency.

As for geopolitics, we still foresee Ukraine as a stalemate, with neither side wishing to be overly-aggressive. We don't expect sanctions or reprisals to deeply affect the global economy, but relations will be testy and Russia has been greatly lost to the G-3. We also expect Iraq to become a stalemate, as neither side can control its rival's areas, although the battle for Mosul could be quite bloody.

Other risks (including China's aggressive territorial claims, North Korea, other MENA unrest, EM political strife, etc..) will likely occasionally instill fears in risk markets, but not likely lead to crisis.

As for Iran, we expect a deal to be completed on schedule. This will increase fears of oil oversupply by mid-year, so despite Saudi efforts to support prices, we expect Brent oil to fall to $52 at end June and remain low thereafter.

We would predict a more major decline if the G-3 and China's economies weren't recovering above consensus, as we forecast. Due to strong global growth, other commodity prices will likely rise, despite a mildly higher USD, so overall commodity prices should remain reasonably flat after a mild 2Q decline.

Bond and Currency Targets

G-3 bond yields were lower than we predicted, mostly due to the ECB's highly aggressive QE program, the winter soft-patch in recent US data and the decline in oil prices. However, due to our view that the global economy will rebound a bit more than consensus (although admittedly primarily because the 1Q base will be a bit below consensus), we expect yields to rise moderately for the next two quarters.

For US 10Y Treasuries, our target for June-end is 2.10%, while those for 10Y JGBs and German Bunds are 0.30% and 0.20%, respectively.

For Australia we expect a rise to 2.5%. This implies (coupled with our forex targets), that including coupon income, the Citigroup WGBI (index of global bonds) should produce a -1.6% return from our base date of March 20th through June in USD terms and -2.7% through September. Thus, we are not positive on global bonds for USD based investors. This index should perform a bit better, at -0.2% in Yen terms due to expected Yen weakness (see below) at end-June and -0.5% at end -September. We target 10Y JGBs to have a +0.4% return in Yen terms through June (and -0.5% through September), and we only have a slight preference for ex-Japan bonds for Japanese investors.

Thanks to Japan's large monetary easing stance vs. a Fed hike policy (even if delayed), coupled with a sharply negative trade balance and higher interest rates abroad, we continue to expect the Yen to weaken in the quarters ahead. We now forecast that June will finish at 122: USD, with 123 at September-end. Elsewhere in the Asia Pacific region, we expect the CNY to be flat vs. the USD at end-September and for the AUD to weaken to 0.76 vs. the USD by then due to the general, but moderate strength in the USD.

As for the EUR, the ECB's aggressive QE program will likely overshadow the region's continually high current account surpluses, and push the currency moderately lower. Our estimates are 1.05: USD at end-June and 1.04 at September-end.