2015 Q4 House Views Update
by Nikko Asset Management's Global Investment Committee
Bond and Currency Targets
Although we expected G-3 bond yields to rise, they did so less than we predicted in September, due primarily to a flight to safety after terrorist attacks, increased expectation of a dovish ECB and lower expectations for global economic growth. We expect yields to rise moderately further for the next two quarters. For US 10Y Treasuries, our target for March-end is 2.40%, while those for 10Y JGBs and German Bunds are 0.35% and 0.65%, respectively. For Australia we expect a rise to 3.0%. Our targets for June-end are 2.50%, 0.40%, 0.7% and 3.10%, respectively. This implies (coupled with our forex targets) that including coupon income, the Citigroup WGBI (index of global bonds) should produce a -1.3% return from our base date of Dec 4th through March in USD terms and -2.3% by end June. Thus, we remain negative on global bonds for USD based investors. This index should perform a bit better, at -0.5% and -0.8%, respectively, in Yen terms due to expected Yen weakness (see below). As for JGBs, we target the 10Y to have a flat return in Yen terms through March and -0.3% at end June, and for the first time in several years, prefer Japan bonds vs. ex-Japan bonds for Japanese investors.
Thanks to Japan's large monetary easing stance vs. a Fed normalization policy, coupled with a negative trade balance and higher interest rates abroad, we continue to expect the Yen to weaken in the quarters ahead. We now forecast that March will finish at 124: USD, with 125 at June-end. We expect the AUD to weaken to 0.71 vs. the USD by end June due to the general, but moderate, strength in the USD and the mild decline in commodity prices. As for the EUR, the ECB's continued dovish stance and 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-March and 1.03 at end-June.
Despite all the disruptions and volatility since our September call to be neutral on global equities, all major markets have rebounded. Even the US market, the only one for which we predicted negative returns, performed well. As for our overweight calls, Europe was only slightly positive in USD terms, but Japan and Pacific ex Japan performed very well. Our new macro-backdrop scenario has moderately more positive ramifications for global equities, with the US rising mildly but the other regions posting substantial gains. Aggregating our national forecasts from our base date of December 4th, we forecast that the MSCI World Total Return Index will rise 2.3% (unannualized) through March in USD terms (3.0% in Yen terms) and 4.3% by June-end (5.9% in Yen terms). These gains in USD terms are not attractive enough to justify a very aggressive stance on global equities (except for Yen-based investors), but we will move back to moderately overweight global equities for US- based investors.
Why did the US equities perform better than we expected? Besides underestimating the reduction of China fears in the US market (although we were not China bears), we also did not predict the M&A spree. While most of these deals have not been approved by anti-trust regulators (and several have been rejected), the M&A premium in the market still exists. The surge in corporate bond spreads also has not deterred M&A activity. As for 3Q earnings, they were better than consensus expectations and analysts did not cut their 2016 forecasts very much, which greatly increased investor optimism.
The SPX is now trading at 16.9 times NTM (next twelve month) bottom-up consensus earnings, which is high in a historical context (and if one fully expenses for option grants, the PE is probably a full point higher). We expect a slight de-rating since bond yields are likely to rise, but given a studier 2016 GDP outlook, we expect a stronger earnings outlook, especially if oil prices stabilize as we predict. Weak emerging market economies (ex-China) and a somewhat stronger USD will remain headwinds, however, so EPS growth should not be superb. In sum, these factors should drive the SPX to 2106 at end-March and 2129 by end-June (1.4% and 3.0% returns respectively), which are obviously quite modest returns given the risk involved.
Eurozone equity prices in USD terms should rebound after three quarters of weakness (greatly due to EUR weakness), with rising corporate earnings and continued regional economic growth being the main factors. The additional ECB easing should also assist sentiment. Even though the EUR in our forecast weakens vs. the USD, we expect a 3.8% unannualized return in USD through March and 6.7% through June, so we will maintain an overweight stance.
Japanese equities rebounded much as we predicted after their weak 3Q. Unfortunately, progress on the most important third arrow, TPP, will be slow and may not occur until the US “lame-duck” session in December. As this becomes realized, it could cause some temporary headwinds for Japanese equities. Fortunately, there are other economic reforms happening, especially corporate governance and further declines in the corporate tax rate. Also, even though Japan's economy is not very strong, this should not concern investors greatly. As we have long reported in our “Show Me the Money” pieces, we believe that Abenomics is working well, especially for corporations, with 3Q pretax profit margins soaring to historical highs for both manufacturing and non-manufacturing sectors. It is, thus, working very well for equity investors too, and should continue to do so, in our view. Indeed, the market PER of 14.8 times our forward earnings estimate is attractive and consensus earnings estimates will likely continue to improve, partly due to a slightly weaker Yen but also due to the moderately improving global economy. In sum, we assume no market re-rating but this still leads us to expect a 3.3% unannualized total return in USD terms through March (TOPIX at 1629) and 5.8% through June (TOPIX at 1675), or 4.1% and 7.5%, respectively, in Yen terms.
As for Asia Pacific, we expect major strength in both Hong Kong and Australian equities. Both will benefit from stronger confidence in the Chinese economy, even though Australia will continue to face some headwinds from lower commodity prices. Recent M&A bids for Australian companies by Chinese companies are helping investor sentiment, as well, and this could expand further into a global trend, as well. Thus, for the region's developed markets, we expect a 4.4% unannualized return in USD through March and 7.6% through June, so we will maintain an overweight stance.
In sum, we forecast that Asia Pac ex Japan, Japan and Europe will outperform in the next six months, while the US should underperform and, thus, deserve an underweight stance vs. all other regions.
The largest risk factor now is increased terrorism in the West, even though the effects of such would not likely be long-lasting. Clearly, geopolitical risk in general remains very high, but particularly within the MENA region, with the situation become more worrisome by the day. Emerging economies also remain a risk, and within such, corporations with large USD debts pose credit risks, especially as credit ratings decline. The large debts within the US shale oil sector are also likely to worsen substantially in the coming quarters, which will likely continue to impact US economic growth and the stability of credit markets. As always, we watch the Ukraine and North Korea with concern, but for now, do not expect any major trouble.
Investment Strategy Concluding View
We forecast that global equities will continue to rise by end March and through the rest of 2016, especially developed markets outside of the US, but do not wish to be aggressively overweight. Due to our expectation for global bond yields to rise moderately and for the USD to continue appreciating, we continue to underweight global bonds vs. USD cash for USD based clients. For Yen based clients, we continue to emphasize Japanese equities and prefer Japanese bonds to ex-Japan bonds.