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

Central Banks

We are shifting our stance on the first hike from October (which is now the approximate market consensus) to September. Furthermore, very much unlike consensus, we believe the most logical path for Fed hikes is 25 bps points per meeting this year. If global economic growth remains firm (with no GREXIT or geopolitical crises),led by a strong US, then it will be hard for the Fed not to hike in September, nor to skip an October hike. We believe the economy, plus the equity and bond markets can absorb this normalization from extremely low rates. The US is near full employment, core CPI inflation is rising, and perhaps most critically, we expect corporate profits to greatly exceed bottom-up consensus estimates in 2015. We estimate that the latter fact will keep the US stock market in positive mode despite moderately rising 10-year bond yields. A positive equity market will be key to continued strong growth in US personal consumption, and thus for the Fed's outlook. As mentioned on the prior page, many experts predicted disaster from tapering, but the opposite occurred, and we see a similar pattern ahead with this rate normalization. Thus, we expect the Fed funds channel rate to be 0.75-1.00% at year-end, although once mostly normalized at this level, we expect only 25 bps hikes per quarter thereafter. To be honest, we do not adhere closely to the Fed “dots” and believe that our path best conforms to Fed guiding terms of “gradual,” “remaining accommodative” and most importantly, “data dependence,” (if the economy is strong, then Fed hikes should respond). The Fed has gone out of its way to say that investors should not expect 25 bps hikes per meeting (as is the historical norm), as the Fed wishes to maintain its flexibility; however, it has not ruled this path out, nor could it ever rule it out if it wished to remain data dependent. Its guidance away from expecting a hike per meeting seems like a swipe at Greenspan's Fed in 2004-2006, but that was a case of hiking rates too slowly rather than too quickly, and the Fed should actually also be wary of raising too slowly this time.

Lastly, we believe that in the 1Q16, the Fed will start guiding the market about a halt in MBS re-investment in the 2Q16. This is hardly ever mentioned by the Fed or in the media, but most professionals are aware of this likelihood, so they should not react negatively.

US inflation has been hard for even the statisticians to monitor due to Obamacare, but we expect the CPI YoY rate to be 0.6% in September, 1.8% in December and 2.1% next March. Core CPI, driven by shelter, is quite firm YoY, at 1.7%, and at a 2.5% 3-month SAAR rate in May. We expect it to be 2.0%-2.1% YoY in December and the following March, which is clearly firm enough for the Fed to hike near its rate to 1.0% in the coming quarters.

In Japan, oil's weakness has decreased the prospects for inflation, but there is less political pressure for the BOJ to ease policy further soon (in fact, there is some pressure for it to refrain from easing), although there is some chance it might do so next year. The economy should continue to improve, so there will be less justification to ease policy for domestic growth reasons, and although the official Core CPI, which includes energy, is low, running at about 0.5% YoY, it should accelerate to 0.8% YoY in December and to 1.1% or over in the following quarters. Notably, housing rent is a significant part of core inflation and it continues to be soft, but it should start rising. Indeed, unless rent starts to rise, it will be very difficult to ever 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, has long-seemed a more appropriate target to us.

As we have said since the initiation of QE, it will be difficult for the ECB to implement the program through September 2016, but there should be no problems for the next two quarters, and, unless GREXIT happens, we expect no other ECB measures this year. Indeed, the rhetoric will likely sound increasing neutral as the ECB declares how successful it has been. This should prevent the EUR from weakening too sharply. Consumer inflation has surprised consensus to the upside in recent months, and should be near 1.0% in December as the base month declines. 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% YoY in the 1Q16 and near 1.6% by 2Q16. As for core inflation, it will likely rise from 0.9% YoY currently to 1.4% by the end of the year. The tail risk is, of course, Greece, but due to our view that Greece will relent (perhaps after a change in government), 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) in the periphery should be the greatest factor in reducing anti-Eurozone sentiment.

As for the BoE, UK inflation is low, but the economy should rebound moderately, so we still expect a 25 bps rate hike in the 1Q16 and 2Q16.

In sum, we have a non-consensus, but completely sound call for a more aggressive Fed, whereas we expect the ECB and BOJ to maintain their current aggressive easing program.