2015 Q3 House Views Update
by Nikko Asset Management's Global Investment Committee

We are shifting our stance on the first Fed hike back to October (sooner than consensus, with many who predicted a September hike suddenly shifting to early 2016) from September (after moving it from October to September in our June meeting). Back in June, our over-optimistic scenario for global markets led to our Fed call being too hawkish on the subsequent hikes, and we now look for Fed hikes of 25 bps at alternating meetings. We believe the Fed was merely scared by the recent global turmoil and that they would later be harshly blamed if they hiked at the wrong time, so they just desired a bit more time to be sure that global markets would stabilize and not provoke a global economic slowdown. They realize that they cannot protect against every risk, and are eager to “get off of zero” and we expect conditions to be stable enough for that by late October. Everyone knows now that October is a possible meeting for the first hike and a telephone press conference may even be preferred by Ms. Yellen, as it is less troublesome than a full press conference. As for December, it is very close to the holidays, so it is not an ideal time for a first hike, but we would suggest that if not October, then December would be likely.

We also thought that with inflation decelerating, especially due to a renewed relapse in oil prices, the Fed would prefer to see some stability in oil prices. Indeed, US inflation has been hard for even the statisticians to monitor due to Obamacare, but due to declining oil prices, we expect the CPI YoY rate to be 0.4% in December and 1.5% in March. Core CPI, driven by shelter, should be reasonably firm at 1.9% YoY in December and March, which is clearly firm enough for the Fed to hike rates further. As a side note, we use the CPI for inflation forecasting because the PCE deflator is often heavily revised, which has been a source of great chagrin by Fed officials in the past, while the CPI is never significantly revised.

For the time being, we are not estimating a date for reducing the Fed’s balance sheet, but a 2Q16 initiation seems quite logical at this stage. There may eventually be strong pressure from the Republican leadership in the Congress for the Fed to reduce its assets, but interestingly, the Fed’s main critic, Senator Shelby, reversed his anti-stimulation theme recently, and did not pressure the Fed to raise rates this last meeting, calling the decision “a tough call.”

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 continues to be some political pressure for it to refrain from easing with an election and the TPP negotiations approaching), although there is some chance it might do so next year. The economy should rebound moderately, 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 0.1% YoY, core inflation excluding energy is about 0.7% YoY. 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 behavior) and that the BOJ is secretly happy with 1.5%, which, to be honest, has long-seemed a more appropriate target to us.

We still do not see any implementation problems for the next two quarters with the ECB’s QE program, and we do not expect any other ECB measures this year. Like the Fed, the ECB is closely watching global markets and emerging economies, but does not appear ready to act soon barring further crisis on these fronts. Consumer inflation will decline in the coming months due to lower oil 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% YoY in the 1Q16 and core inflation will likely rise from 0.9% YoY currently to 1.1% by the end of the year. The tail risk is, of course, Greece, but we still think it will avoid catastrophe and implement, at least in the short term, its program. 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.