2015 Q4 House Views Update
by Nikko Asset Management's Global Investment Committee

At our September meeting, we expected the first Fed hike in October (which was slightly early, but we strongly felt a delay until 2016 was unnecessary), and now, like consensus, we expect such in December and for further hikes of 25 bps at alternating meetings through 2016. With inflation decelerating, especially due to a renewed relapse in oil prices, the Fed would prefer to see some stability in oil prices, so it may be very dovish in its rhetoric until such occurs. Indeed, there may even be several dovish dissents at the next meeting, namely by Tarullo, Evans or Brainard. The recent terrorist attack's effect on the economy will have to be monitored too. On the positive side, Core US CPI inflation should remain reasonably firm at 1.9% YoY in 1H as medical prices start to rebound and shelter costs remain high. 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. Meanwhile, we are not estimating any reduction in the Fed's balance sheet in 2016, but if the global economy holds up well, there will likely eventually be strong pressure from the Republican leadership in the Congress for the Fed to reduce its assets near the end of the year.

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 the Japanese Diet election and the TPP vote in the US later in 2016), although there is some chance it might ease if the Yen strengthens to 110-115. 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 very low, excluding food and energy, it is 0.7% YoY and likely accelerate above 1.0% in the quarters ahead. 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.

Back in September, we did not expect any ECB easing, and as it turns out, its recent move was not so significant, as the monthly size of QE purchases was not increased and the extension of the program was not a major development. Indeed, only a small rate cut in one category occurred. Along with the negative effect of the Paris attack, the ECB is closely watching global markets and emerging economies, but the hawks believe QE has improved the economy already and more QE may be counterproductive. We only expect mild further easing ahead, especially as the ECB does not wish to cause a rupture while the Fed is hiking rates. Furthermore, while consumer inflation will decline in the coming months due to lower oil prices, core inflation will likely rise from 0.9% YoY currently to 1.5% by the end of 2016 due to increased economic growth, pass-on costs of EUR weakness and increased residential rents.

As for the BoE, UK inflation is low, but the economy should rebound moderately, so we expect a 25 bps rate hike in the 3Q16 and 4Q16. Meanwhile in China, we expect the PBOC to reduce interest rates and the reserve ratio requirement three times in the next year, which should support the economy and risk market sentiment significantly.

As for geopolitics, clearly the increase in ISIS related terrorist attacks in the West are a larger risk factor. Attacks in MENA are also possible too. Worries about such will rise and fall, but the overall intermediate-term effect should be minor. 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 oil, Iran is already disgorging its large storage of condensates and its future oil exports will continue to instill fears of oil oversupply (including the overproduction of many other OPEC countries), along with very high global oil inventories. US production is finally declining, but we still expect Brent oil to be $43 at end June and remain there at following quarter-ends. This was its price when we made our targets and it has since fallen to $40, but given the recent increase in MENA's upheaval, especially the dangerous involvement of Russia vs. Turkey and the rise of terrorism since ISIS's oil industry was attacked, we believe that oil prices will start to be supported to some degree by MENA supply worries. Also, there is a chance that the Saudis, fearing excess fiscal deficits, will “declare victory” over the US shale industry and start to make positive comments about oil prices, but there does not seem to be any sign of such and no analysts seem to be predicting it either. However, credit stress is rising rapidly in the US shale sector and some methods to maximize short-term production (as the cost of inefficient depletion) may be faltering, so US production could start to decline more rapidly than expected. As for other commodity prices, they will likely decline a bit further, partially due to a stronger USD, but with sturdy economic growth in the US and China providing some tailwinds.