Nikko Asset Management's Global Investment Committee (GIC) met for its quarterly review of global
economic conditions. Based on the findings of its senior investment professionals around the world, the
company periodically reconsiders house views on the major global markets and asset classes.
Despite the UK's decision to leave the European Union, the Global Investment Committee has noted that it
does not think economies or risk markets will crash, but added that it is hard to be enthusiastic about the
prospects for the post-BREXIT world over the next few quarters.
In conclusion, the investment committee has forecasted that global equities will decline a bit further and
has initiated an overall underweight stance, regionally overweighting Japanese and U.S. equities. Due to the
committee's expectation that global bond yields will decline moderately, it will overweight global bonds
and USD cash for USD-based clients. For Yen-based clients, the committee emphasized fixed income
investments as well.
The full report written by John Vail, Chief Global Strategist and Chairman of the GIC, is as follows:
Slowdown but No Global Recession, with EU Cohesion, but Struggling UK
Note: before the BREXIT vote, our Global Investment Committee (GIC) chose from three scenarios for each
outcome; thus, the following market and economic targets for our BREXIT scenario were made before the
Given the UK's decision, our Global Investment Committee does not think economies or risk markets will
crash, but it is hard to be enthusiastic about the prospects for the post-BREXIT globe for the next few
quarters. The tumultuous US Presidential campaign will not help sentiment either. In sum, we expect an
average of about one percentage point will be lopped off from recent GDP trends in major countries
during the next four quarters, while the UK will likely descend into a moderate recession. We have
never been intense Euro-skeptics, and we still believe that the Eurozone will remain intact, and that no
other country will leave the EU, as the UK is an unique country and the trauma of exiting would be too
great for the majority of any EU member's voters to approve, but it will obviously be a tumultuous period.
Clearly, the negotiations of UK's exit will be important to watch, as we believe the EU will be fairly generous
on the goods trade, but quite harsh on the services trade and the timing of the exit, as although they don't
wish to hurt themselves too much, they need to make sure that no other country thinks it is easy to leave
the EU or renegotiate the terms of its inclusion.
As for the major economies, US consumer spending in real terms should moderate from high current levels
and capex will likely remain negative. At 1.5% Half on Half Seasonally Adjusted Annualized Rate (HoH SAAR)
in both the 2H16 and 1H17, GDP will be far from recessionary conditions, but much lower than the circum
2.3% (pre-BREXIT) consensus expectation. Japan's GDP will likely grow at a very subdued 0.5% HoH SAAR in
the 2H16 and a bit higher in 1H17, compared to the consensus of 1.2% and 1.0%, respectively, with net
exports and capex being the primary culprits. Eurozone GDP should dip to near zero in the 2H16 but
expand by 0.4% HoH SAAR in the 1H17, vs. the (pre-Brexit) 1.7% consensus for each period. Here too,
consumer spending should decelerate, along with capex and net exports. China's official GDP should
achieve 5.9% HoH SAAR growth both in the 2H16 and 1H17 periods (translating to about 6.0% YoY growth),
vs. the 6.4% consensus. Many of its heavy industries will likely be sharply curtailed by reform efforts and
trade restrictions, but its services sectors should perform fairly well.
Other Emerging economies, having stabilized somewhat in recent quarters, are likely to decelerate
substantially again due to lower commodity prices, lower global trade and continued political turmoil in
many countries. External debt in USD terms, both bonds and bank debt, of EM corporates remains a critical
factor to watch, especially as the latter can be withdrawn relatively quickly. Rating agency downgrades of
the corporations, often linked to declines in the sovereign rating, are occurring much more rapidly these
days and some of these corporates are very large debtors, especially in Brazil, one of the largest of which
recently filed for bankruptcy.
How will Central Banks Respond?
Given Brexit, we do not believe the Fed will hike rates until December or later, while market consensus has
now shifted to only about 10% chance of a December hike. With Brent declining to $46 at end September
due to decelerating global economic growth, and by another $2 in each of the following two quarters, the
US CPI is likely to hover around 1.2% YoY for the next several months and decline to 1.0% YoY at year-end
(with core CPI at 1.7% YoY at that time). Even with non-farm payrolls growing at 100K/month and the
employment rate below 5%, the Fed will be extremely hesitant to raise rates through year-end. As for both
the BOJ and ECB, we only expect moderate cuts in the policy rate in the coming quarters, as policy is already
extremely accommodative and doing a great deal more could well unleash fears of a monetary crisis. As for
the BoE, we expect a 25 bps rate cut in the 3Q16 and in China, we expect the PBOC to reduce interest rates
and/or the reserve ratio requirement several times in the coming quarters.
Brexit and US Elections
The US elections will be key to market sentiment in the coming quarters. The BREXIT outcome seems to
boost Trump's chances, but if the UK economy and markets, including real estate, decline substantially on
this news, such would likely detract from Trump's chances. Investors will be very wary of US polls and
betting odds, so uncertainty will increase further and the fact that both candidates are anti-big business and
anti-Wall Street, coupled with populist views on the current global trade and corporate tax regimes,
confidence in US corporate profits will decline. Even if the Republicans win one chamber of Congress, both
candidates have resolved to use executive orders and the bureaucracy to advance their goals without
Lower Bond Yields, a very weak GBP, but Stable Yen
Given our new scenario of economic deceleration, we expect yields to decline even further for the next two
quarters. For US 10Y Treasuries, our target for December-end is 1.45%, while those for 10Y JGBs and
German Bunds are -0.25% and -0.10%, respectively. For Australia we expect 1.85%. This implies
(coupled with our forex targets) that including coupon income, the Citigroup WGBI (index of global bonds)
should produce a 0.8% return from a base date of June 24th (after the BREXIT vote) through September in
USD terms and +1.7% through December. Thus, we move to an overweight stance on global bonds for
USD-based investors. This index should also perform well, at circum 1.5%, through September and
December in Yen terms, and as for JGBs, we target the 10Y to have a 0.7% total return in Yen terms through
December, so we are reasonably positive on both domestic and global bonds for Yen-based investors.
Thanks to Japan's continued super-aggressive monetary stance vs. the Fed, coupled with Japan's weaker
economic growth relative to the US, we expect the Yen to stabilize at 103:USD at end-September and
102 by end-December. We expect the AUD to strengthen to 0.720 and 0.710 vs. the USD over those same
time periods due to weaker global economic and commodity sentiment. As for the EUR, we do not believe
the ECB will make any major QE moves and the region will continue its high current account surplus, which,
coupled with likely capital repatriation, should push the currency to 1.14 and 1.15, respectively. Investors
will likely be surprised by the eventual cohesion of the EU, as well. On the GBP, we take a very bearish
view, expecting it to decline to 1.30 and 1.27, respectively, as troubles continue to mount politically and
economically, while the BOE cuts rates and potentially even launches QE.
For those interested in the "barbarous relic," we expect gold at $1350 by end-September and hold that value
Shifting from Neutral to Underweight on Global Equities
We have been cautious on global equities since September and our new macro-backdrop scenario
results in a moderately negative view on global equities, particularly in Europe. While we don't
expect major problems for the currency or EU cohesion, the corporate profit outlook in Europe will
suffer. Equities should not perform too badly in the Eurozone, but the UK profit outlook will be quite poor,
especially as the financial sector loses some access to the EU, and coupled with our very bearish GBP call, we
expect continued very weak returns from the FTSE by the end of September. Aggregating our national
forecasts from our base date of June 24th, we forecast that the MSCI World Total Return Index will
decline 3.8% (unannualized) through September in USD terms (3.0% in Yen terms) and recover a bit in the
4Q to return -2.9% from our base date through December in USD terms (3.0% in Yen terms). We only
expect a mild global equity rebound in the 1H17, as well, with continued negative returns from our base
date. Thus, we will shift from a neutral to underweight stance on global equities for USD- based
investors (and Yen-based investors, as well).
Why are we moderately bearish on US equities? If this crisis had hit when US equities valuations were at
more reasonable valuations, we would not be as cautious, but we still think the market is too expensive and
is trading more on dividend yield than PER ratios. With falling bond yields, this dividend yield effect should
remain to some degree, but the rationale of this kind of investing depends (except for the most defensive
sectors) greatly on the prospect of future earnings and global risk sentiment. Buying just for an additional
1% dividend yield over bond yields will not seem too advantageous when equity prices decline 10% and
the dividend yield only rises slightly further due to such. Indeed, even after Friday's decline, the SPX is now
trading over 17 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, and this
does not even include the recent expansion of supposedly one-off write-offs). Thus, we expect a moderate
de-rating due to lower global economic growth prospects, corporate profit outlook (especially with
the USD stronger since BREXIT) and risk appetite. One source of support is continued share buybacks,
which are not affected much by economic fundamentals, while on the other hand, many hedge funds and
volatility-based macro funds will likely be forced to deleverage. We believe uncertainty over the US election
will also cause market jitters. In sum, these factors should drive the SPX to 1966 at end-September (-2.9%
total return from our base date), and to 1981 (-1.6%) through year-end, which is obviously poor given the
risks involved, but because this result is better than average, we return the US to a regional overweight for
Eurozone equity prices in USD terms should fare similarly poorly in USD terms, for fairly clear reasons, with
Euro Stoxx declining to 278 and 280, by end September and end December, respectively. FTSE, however,
should decline to 5650 in each of these two periods, which Is a circum 11.5 % loss in USD terms through
both periods. In sum, we will take an underweight stance on the region for USD-based investors.
Although many investors complain bitterly about Japanese equities, they actually performed in line
with global developed-market equities through the 2Q in USD terms. The stronger Yen certainly has
been a headwind, but coupled with low equity valuations and our expectation that the Yen will stabilize, we
expect TOPIX to basically stabilize from its June 24th's close, ending September at 1208 and December at
1184 (for a total return of -0.3% in USD terms and -0.5% in Yen terms). As important drivers, corporate
governance continues to improve and buybacks are surging. 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 reasonably well, especially for corporations, with 1Q16 pretax
profit margins (on a four quarter average) remaining near historical highs, within which the nonmanufacturing
sector remained at its peak. On an after-tax basis, the improvement is even better due to
lower corporate taxes. Abenomics is, thus, working very well in many regards, and in Japan, we do not see
political disruption because it has maintained a highly egalitarian public policy despite being longridiculed
by most Western investors and economists for such.
As for the Developed Pacific-ex Japan region, we expect weak results in both Hong Kong and Australian
equities through September and December, as both will be hurt by the decelerating global economy and
weak global investor sentiment. Thus, for the region's developed markets, we expect a -5.8% unannualized
return in USD through September and -6.7% through December, so for USD-based investors, we will take
an underweight stance on the region.
In sum, we forecast that Developed Pacific ex Japan, and Europe will underperform in the next six
months, while the US and Japan should outperform and, thus, deserve overweight stances.
As for geopolitics, clearly the increase in ISIS-related terrorist attacks in the West is a large risk factor now.
Widespread attacks within MENA are also quite possible too, which could impact oil supplies. Worries about
such will rise and fall, but the overall intermediate-term effect should be moderate. Other risks (including
China's aggressive territorial claims, North Korea, Ukraine, other MENA unrest, EM political strife, etc.) will
likely occasionally instill fears in risk markets, as well.
As for economic and credit risks (excluding the worst case scenarios of EU disintegration, a disruptive US
election, or a wildly troubled UK), some speculators were likely badly damaged by the recent volatility, and
there will likely be several credit events related to such, particularly in derivative markets and in the hedge
fund arena. Whether this spreads to financial system fears is obviously important to watch. Elsewhere,
emerging economies also remain a risk, and within such, corporations with large USD debts pose credit risks,
especially as credit ratings decline. The likely default and messy workout of Puerto Rico, which would be
one of the largest in history, does not help either, even if it contains some unique factors. The large debts
within the US shale oil sector are also likely to remain a problem in the coming quarters as the oil price
Investment Strategy Concluding View
We forecast that global equities will, overall, decline somewhat further, so we will take an
underweight stance overall, regionally overweighting Japan and the US. Due to our expectation for
global bond yields to decline moderately further, we will overweight global bonds and USD cash for
USD-based clients. For Yen based clients, we emphasize fixed income investments, as well.
Note: all dates in this report are Calendar Year (CY)-based unless otherwise specified.