There was a large hue and cry about the recently announced Japanese GDP statistics that indicated that the country was in a recession. There are three important things to know about this, however…

1. Firstly, these statistics often get heavily revised and it would not be shocking to see the most recent quarter revised up into positive territory, especially as there were several anomalies in the data.
2. Secondly, GDP statistics have no correlation with corporate profits in Japan. As our Evolving Markets reports have long-shown, despite lackluster GDP, Japanese corporate profits have been quite strong in the last 10 years. Indeed, in the last two quarters of this supposed recession, Japanese corporate profits have surprised sharply to the upside and grew about 10% year on year; hardly an indication of crisis. Of course, the weaker Yen played some role in this, but service sector profits, including among banks, also surprised to this upside.
3. Thirdly, there are manifold indications that the calendar fourth-quarter’s economy will rise significantly as machinery orders and personal consumption remain on an upward track. Meanwhile, if this recent GDP data leads to further yen weakness, such would also be supportive of the economy.

The political aspect of these numbers however, is more significant and will likely cause the consumption tax hike to be postponed. This is positive news in the short run, as it will allow the economy to grow and the wealth effect to spur future consumption.

It will also likely lead to new elections which should bolster the Abe administration’s hold on power for the next few years and, thus, bolster his ability to reform the economy. In particular, this should increase his ability to push through an agreement on the TPP, which is a badly needed development for Japan

In sum, the bad economic data should not worry investors in Japanese risk assets very much at all.

– John Vail, Chief Global Strategist Nikko Asset Management

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Peter Sartori

The recent turbulence in markets is resulting from several non-economic factors, such as the Ebola outbreak, sanctions imposed on Russia related to the ongoing turmoil in Ukraine, and plummeting oil prices as Saudi Arabia maintains its high oil production, according to new research by Nikko Asset Management. The Tokyo-based firm nevertheless expects risk markets to withstand the events and continue their upward march.

“Our target for the S&P 500 is a slight rise above its recent level and continues to look quite achievable once some of the panic surrounding these issues calms,” said John F. Vail, chief global strategist and chairman of the firm’s global investment committee.

Meanwhile, in the Asian region, relatively stable political regimes are translating into meaningful economic gains in certain countries, according to Peter Sartori, the head of Asian equity based in Singapore.

“Asia’s moment is now for the taking, and the next 12-24 months will be critical for shaping investors’ image from one of a perpetually emerging Asia into one that has finally emerged,” Sartori said. “Indisputably, sound political systems are crucial for economic development and progress.”

The firm’s analysts point out that Singapore, which has had a single political party in power over a prolonged period of time, has seen its economic growth contract in only five short periods over the last 53 years. The Philippines and Indonesia, too, managed to carve out an enviable sustained economic growth path over long periods where political power was absolute.

China’s economic transformation within its ongoing communist political structure has allowed the country to become the world’s second-largest economy in the short space of 36 years. Its new leader, Xi Jin Ping, is the only person to concurrently hold the highest office of the party, state and military, within his first term in office. “He moved quickly to eliminate corruption, leaving virtually no office untouched,” Sartori said. “China bears should be afraid, especially as the market has been marking a bottom for the last two years; still a substantial 60 percent from the high point reached in 2007.

India, on the other hand, may now be poised to join the ranks of more politically stable countries, thanks to the Bharatiya Janata Party’s resounding general election win in May, the first time in 30 years that a single party secured more than 50% of the government.  “Can the BJP under Narendra Modi deliver policies that will lift the living standards of the poorest and deliver sanitation to the slums? Market expectations are high,” Sartori noted.

Elsewhere in the latest edition of Nikko Asset Management’s Evolving Markets report, the firm’s analysts note that household net financial assets in Japan (excluding real estate) reached a historical high, according to second-quarter data, of \1.29 quadrillion (US$12.6 trillion)　in Japan. The so-called “wealth effect” has been underestimated by local and foreign investors, though in other countries it is a linchpin of economic recovery: “’Asset Bubble Economics’ (ABE) is a phrase that is lightly bandied about,” Vail commented, “But the role of inflating asset prices, while keeping interest rates down, has been the hallmark of the U.S. economic recovery.”

The administration is also serious about making improvements in corporate governance as one of a series of economic stimulus policies. It is expected to start emphasising the importance of dividend payouts, congratulating those companies who raise ratios sharply and criticising those who fail, the report said.

“Foreign investors will realise that corporate governance in Japan is a very serious trend, along with the recent surge in profit margins, and gain confidence in the country,” Vail said. “The implications of this trend are huge as the impact of growing asset wealth and income for individual and institutional investors will be the key to the continuing success of Abenomics, so we expect Japan’s leadership to encourage dividends.”

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Nikko Am Evolving Markets report -September 2014

Nikko AM’s Global Investment Committee (GIC) met on 26 September and chose a relatively positive global-macro scenario, implying an increased overweight stance on global equities.

Primarily, we believe that the G-3 economies will move steadily ahead and that US monetary conditions, although moving towards tightening, will remain very accommodative (with the Bank of Japan (BOJ) and European Central Bank (ECB) being even more so), allowing equity markets to move higher.

In this edition, we also update some of our Abenomics guideposts on corporate profitability, wealth effects and inflation trends. We continue to suggest that Abenomics, while not perfect, is working well, especially for corporate profits, with perhaps the most compelling recent news being the progress towards a major corporate tax cut, which is more a bazooka than an arrow, in our view.

Click here to read the report.

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• The global economy is still on the mend, but it’s still a two steps forward, one step back affair. Of the major regions the US is doing the best, but Europe is lagging.
• This means occasional bouts of uncertainty, but it’s not such a bad thing if it keeps central banks supportive.
• The main implications are: we are still in the sweet spot of the global economic cycle, which is good for growth assets; the lack of global synchronisation means that fundamentals for individual regions, assets and stocks matter; constrained global growth will mean constrained returns; and the big event to watch for is when the Fed starts to hike rates – but it still looks a way off at present.

Introduction

We are having yet another year where investors started off optimistic about the global economic outlook with talk of synchronised growth only to find that the global growth story remains patchy. In fact, so much so that it’s possible to paint wildly different pictures as to the outlook – some are worried about growth and inflation taking off, whereas others warn of imminent collapse. The truth is likely to remain somewhere in between these extremes. But, in a way, this is not a bad thing as it keeps central banks supportive.

This note looks at the major regions in terms of growth, inflation and interest rates and what it means for investors.

The US – looking good but not booming

After a contraction in the March quarter driven by mostly temporary factors, the US economy rebounded in the June quarter and looks on track for growth of around 3% in the current quarter. The jobs market and business investment are improving and the shale oil boom is providing a long term boost both directly and indirectly via cheap electricity costs for business. However, while the US is looking a lot stronger it’s a long way from booming, let alone overheating, with growth seemingly stuck in a 2-3% range as the housing recovery and consumer spending have slowed a bit of late.

Which brings us to what the Federal Reserve will do. On the one hand US growth has improved enough to allow the Fed to continue “tapering” its quantitative easing program which means it’s on track to end probably in October. On the other hand it’s unclear that conditions are strong enough to warrant interest rate hikes just yet. This is something the Fed is grappling with, but the conclusion seems to be that – with inflation remaining low at just 1.5% on the Fed’s preferred measure, wages/labour cost growth stuck around 2% and broad measures of labour market slack (ie allowing for the unemployed, underemployed and discouraged workers) remaining high – its unlikely to rush into raising rates.

Our assessment is that the Fed is gradually inching towards an interest rate hike, but it’s probably not going to occur until sometime in the June quarter next year.

The Eurozone – better but not great

The Eurozone returned to growth about a year ago but it is far from robust and stalled in the June quarter with weakness in Germany, Italy and France. Uncertainty regarding Russian sanctions and Ukraine are not helping. What’s more bank lending growth has remained negative and inflation has fallen to just 0.4% year on year. This has all led to concerns that Europe is sliding into Japanese style stagnation and that the ECB needs to do more.

Our assessment though is that Europe is gradually mending: growth has returned to Spain, Ireland, Portugal and Greece; these countries have all made significant structural reforms to their economies and France and Italy look to be gradually heading down that path; the troubled countries have all seen their bond yields collapse, eg Spain’s 10 year bond yield is now just 2.17%; the ECB announced further stimulus in June, but looks to be ready to launch into quantitative easing involving the purchase of private debt in the next few months; and bank lending should improve once the ECB’s bank stress tests are out of the way in a few months.

Japan – Abenomics on track

Japan’s growth was hit in the June quarter by the pull- forward effect of the April sales tax hike. However, a range of indicators suggest that despite the volatility the Japanese economy has weathered the sales tax hike well with ultra-easy monetary policy and economic reforms providing confidence growth will bounce back from the current quarter.

However, given the uncertainty, the Bank of Japan will either have to maintain its very easy monetary conditions or possibly have to ease further.

China running hot and cold

For the last three years now Chinese economic data has been running hot and cold every six months leading to periodic worries about growth. Another slowdown in the Chinese property market is adding to these concerns.

With the Chinese Government repeatedly indicating that there is a floor to growth of around 7%, and supporting this by mini-stimulus measures as they have done this year, our assessment remains that the Chinese economy is on track for growth of around 7.5%. But don’t count on more.

Emerging world

The emerging world more generally is a lot messier than it used to be. Of the major’s, China and Mexico look ok and the election of reform oriented governments in India and Indonesia is positive, but Brazil looks to have lost the plot under the current Government, and Russia already weakened looks to have shot itself in the foot over Ukraine. A lack of structural reforms over the last decade has led to lower growth potential in the emerging world. That said it’s still on track for growth around 4.5% this year and next.

Global growth – two steps forward, one back

Bringing this together, global business conditions indicators are consistent with good but not booming growth.

Although global growth is likely to pick up, it’s hard to describe global conditions as synchronised and the global economic expansion remains very much a process of two steps forward, one step back. This was clearly evident in the first half of the year with the US and Japan both having negative quarters, China slowing in the first quarter and Europe stalling in the June quarter. And of course geopolitical events continue to wax and wane and the threat from Ebola remains in the background – all of which impart a deflationary impact in terms of their dampening impact on confidence and spending. Against this backdrop it is hard to see the Fed wanting to rock the boat prematurely with talk of interest rate hikes, let alone actual hikes, and the ECB, Bank of Japan and People’s Bank of China are likely to maintain ultra-easy policy or ease further.

Investment implications

There are several implications for investors. First, gradually improving global growth, still benign inflation and easy monetary conditions tell us we are still in the sweet spot of the economic cycle which augurs well for growth assets.

Second, the desynchronised global economic and monetary cycles confirm that the “risk off, risk on” phenomenon of a few years ago where all growth assets move up and down together has faded. This should make it easier for fund managers and investors to benefit from opportunities in individual regions, assets or stocks. Eg we think there is currently good value in Chinese shares, European shares and commodities. The divergence in monetary cycles is also likely to mean upwards pressure on the $US but downwards pressure on the Yen and Euro.

Thirdly, the constrained global growth cycle provides a reminder not to expect double digit gains from growth assets year after year. It will still be a relatively constrained world in terms of sustainable returns.

Finally, the big thing globally to keep an eye out for will be when the Fed will start to raise interest rates. This, or rather its anticipation, will likely cause a few bumps (just like last year’s taper tantrum did), but it’s still a fair way off and when it does come its unlikely to spell the end of the cyclical bull market in shares as it will be a long while before monetary conditions actually become tight.

By Dr Shane Oliver, Head of Investment Strategy and Chief Economist, AMP Capital

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Shinzo Abe’s “third arrow” radical plan to revive Japan’s economy.

Japan’s parliament in June began debating legislation that would allow for the country’s first casinos. Whatever the merits casinos are as tourist attractions as the bill’s backers claim versus the social ills that opponents allege will flow from their opening, they form part of the so-called third arrow, or economic reform part, of Prime Minister Shinzo Abe’s radical plan to revive Japan’s economy.

Other measures are more standard fare in a package of economic reforms that was announced in June by Abe, who started his second term as prime minister in December 2012. They include changes for the labour market, cuts to company taxes, plans to enter into more trade agreements to open up sectors such as agriculture, special zones where red tape is reduced and changes that allow for economies of scale in the ownership of farm lands.

The third arrow could well be the most revolutionary in terms of how it could change Japanese society and the economy for years, bearing in mind that it can include (and exclude) any of the proposed regulatory changes or economic reforms that are often announced ad hoc. The first two arrows of Abenomics are fiscal stimulus, which is now being reduced, and further loosening of monetary policy – a radical change in itself because it involves central-bank asset purchases that aim to double the monetary base within two years to turn deflation into inflation and achieve consistent GDP growth per capita.

The Abenomics experiment was begun in May last year to resuscitate the economy of a politically stable country beset by two decades of stop-start growth, a decade or so of deflation, the world’s biggest pile of government debt, falling real wages and a shrinking and aging population. The results, so far, are promising for an economy that Bloomberg estimates is 3.5% smaller than when Abe first came to power in September 2006. (He lasted two years.) The economy has expanded for five straight quarters and generated inflation. Investment, production and business confidence have improved and a lower yen is helping exporters. Readings of these measures, however, are not improving enough to lift Japan’s long-term growth projections.

One big challenge for the economy now is that, in an effort to tackle its debt, the government boosted the sales tax by 3 percentage points to 8% on April 1 this year. The resulting drop in consumer spending is expected to shrink the economy over the second quarter. (The tax rise boosted core consumer inflation to a 23-year high of 3.2% in the 12 months to April this year. Core consumer prices are rising at an estimated 1.3% pace when tax effects are excluded.) This means the vague third arrow has taken on greater significance as a means for reviving Japan’s economic future, particularly as Tokyo wants to become a stronger regional economic and political counterweight to China.

Shadowy arrow

The reforms announced in June were generally vague. The government, however, was most specific in saying that it wants to reduce the corporate tax rate from 35.6% to below 30%, where Australia’s rate sits. It is still to outline, however, how it will replace the lost revenue to stop adding to the government’s gross debt that amounts to about 240% of GDP.

The more-abstract announcements cover tougher corporate governance rules, including measures to untangle crossholdings among companies, to boost shareholder returns. They embrace enhanced ability for super funds to buy equities. Among others are changes to farming that allow for the consolidation of small farms and proposals to end utility monopolies to make the energy industry more efficient. Proposals for the labour market could be among the most contentious because they comprise proposals to allow more immigrants in a monocultural and homogenous society, tax changes to encourage higher female participation and steps to boost their numbers at executive level (which might be counterproductive to the government’s hopes to boost the birth rate) and more flexible labour laws. “In my growth strategy, there are neither taboos nor sacred cows,” Abe said in a televised address on June 24.[1]

Abe’s government needs to prove it can turn announcements into regulatory and legal achievements. The vested interests Abe confronts are significant. The severity of the challenges facing Japan may well give him the best-possible environment to succeed.

The fate of the legislation covering casinos may well provide a gauge as to whether or not Abe can overcome vested interests. For among the opponents of Las Vegas-styled and owned casinos are the Japanese businesses that operate various forms of legal gambling, from lotteries and gaming machines to sports betting, who fear foreign competition more than they are troubled by any social ills that might come with casinos.

Financial information comes from various media sources including The Wall Street Journal and Bloomberg.

[1] The New York Times. “Shinzo Abe’s bid to shake up corporate Japan.” 24 June 2014. http://www.nytimes.com/2014/06/25/business/international/shinzo-abes-bid-to-shake-up-corporate-japan.html?hpw&action=click&pgtype=Homepage&version=HpHedThumbWell&module=well-region&region=bottom-well&WT.nav=bottom-well&_r=0

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• Japan’s economy appears to be weathering the April sales tax hike well and Abenomics looks to be working.
• Third arrow supply side reforms are very positive.
• The success of Abenomics augurs well for Japanese shares, which are now cheap. It’s also positive for Australia as Japan is our second largest export market.

Introduction

It’s now over 18 months since Japan embarked on a program designed to reinvigorate its economy under Prime Minister Shinzo Abe, which has become known as “Abenomics”. Growth has rebounded, deflation has given way to inflation and Japanese shares are up around 70%. But is Abenomics working or are we just seeing another cyclical bounce? And what does it mean for investors?

Three arrows

Since the Japanese bubble economy burst at the end of the 1980s, it has wallowed with sub-par growth, six recessions, chronic deflation and a secular bear market in shares and property. Many reasons have been given: a failure to realise how serious the problem was; a conservative approach to policy making; a focus by the dominant Liberal Democratic Party on protecting special interests; revolving door political leadership with 16 prime ministers since 1990; and a declining population.  Regardless of the drivers, Shinzo Abe and the LDP were elected with a mandate to fix up Japan in December 2012 and with voters giving him control of the upper house of the Diet, Japan’s parliament, in July 2013.

Abe is both an economic rationalist and a Japanese nationalist. A key motivation is likely his desire to see Japan’s regional standing strengthened in the face of China’s rise and North Korean threats. He has acted very decisively. His policy response has been characterised by “Three Arrows”: fiscal stimulus, monetary stimulus and supply side economic reforms. All with the aim of boosting inflation to 2% pa and real economic growth to 2% pa.

Given Japan’s large public debt, any fiscal stimulus has to be modest and supply side reforms always take time so the initial focus has been on monetary stimulus. On this front, the approach has been very aggressive with the Bank of Japan announcing a 2% inflation target in January last year, Abe appointing ultra dove Haruhiko Kuroda as central bank governor and the BoJ announcing a massive quantitative easing program (pumping cash into the economy by purchasing $US75bn/month of assets using printed money) in April last year. Adjusted for the size of the economy this was more than double the size of the Fed’s then quantitative easing program and with the latter being reduced now swamps it. The program has seen the Yen fall by 21%.

The initial response has been positive with the economy growing 3% over the year to the March quarter and inflation (ex the impact of an April 1 sales tax hike) running at 2.2%. But concerns remain: that the sales tax hike from 5% to 8% will drive a slide back into recession as the last sales tax hike in 1997 arguably did; that boosting inflation has only led to a fall in real wages; that the BoJ’s success in achieving sustained inflation will depend on the Yen continuing to fall; that Japan’s poor fiscal position dooms it long term; and that the Government has not delivered enough in terms of the third arrow reforms. Let’s look at each of these in turn.

Japan weathering the sales tax hike well

A return to recession as followed the 1997 sales tax hike is unlikely because unlike in 1997 Japan now has quantitative easing, unemployment is falling, property prices are rising, bank lending is rising, banks now have small non-performing loans and business confidence has been rising.

A range of indicators have bounced back solidly from their recent sales tax related fall:

• The Economy Watchers outlook index is up strongly;

• The outlook components of the BoJ’s Tankan survey are strong and business investment plans have improved;
• The unemployment rate has fallen to 3.5%, its lowest since 1997, and the ratio of job vacancies to applicants is at its highest since 1992.

• While overall household spending remains weak after the tax hike, retail sales rose solidly in May.

The overall impression is that the Japanese economy has weathered the sales tax hike reasonably well and that a re-run of the 1997 experience is unlikely.

Ending deflation is key

Rising real wages, when inflation was negative, didn’t exactly help Japan. Rather, deflation was the much bigger problem because it zaps spending – why spend or invest today when you know it will be cheaper tomorrow? The key was to first end deflation and institute an inflationary mindset and Japan has done this with the introduction of a 2% inflation target for the BoJ and backing this up with unprecedented monetary printing. Inflationary expectations are now starting to rise in response and with the labour market stating to look tight wages growth is likely to pick up. Large firms already seem to be starting to put through faster wage increases.

More domestic focus going forward

The decline in the Yen was clearly important in initially driving inflation higher. Our assessment is that a further decline in the Yen is likely – as the BoJ’s huge money printing program, which likely won’t be increased but will be extended beyond its two year timeframe, and the Fed’s taper means that the supply of Yen is rising relative to the supply of US dollars. However, with an inflationary mentality starting to become more entrenched a falling Yen won’t be as important in driving Japanese inflation going forward. In fact this is evident in a breakdown in the negative correlation between the Japanese shares and the Yen recently.

Japan’s fiscal problems bad, but not that bad

Japan’s public debt looks horrible with gross public debt of 244% of GDP (compared to just 31% in Australia!). However, it’s not nearly as bad as it looks. First, its gross public debt of 244% of GDP falls back to 137% once assets such as Japan’s foreign exchange reserves are allowed for. Second, Japan borrows from itself, with public borrowing being a mirror image of private sector savings. Thirdly, various reforms over the last decade will limit growth in pension and health spending. Fourthly, tax as a share of GDP is low by OECD standards in Japan and there is plenty of scope to further increase the sales tax rate from 8%. Finally, while some fret that rising bond yields will blow out Japan’s interest bill this won’t be a problem if the back up in yields reflects stronger growth & inflation as it will mean higher tax revenue.

Third arrow reforms are being understated

A critique of Abe seems to be that he has been lax in delivering “third arrow” reforms. But several points are worth noting. First, it was always second order. Japan’s problem is a lack of demand not supply, as evident in falling prices. And supply side reforms often make things worse before they get better. So it was right to first focus on reflation.

Second, Japan’s third arrow reforms may seem more like a “thousand needles” but they are adding up. A range of reforms have been announced in recent months, eg easing visa requirements, cuts to rice subsidies and eased factory regulations. On top of this the Government has released its “New Growth Strategy” which includes a range of measures including a plan to cut the corporate tax rate from currently 36% to in the 20-30% range, measures to boost female workforce participation and measures to allow more foreign workers in certain sectors. These are all far reaching and while one “big bang” reform should not be expected the gradualist “thousand needle” approach is very positive. For example, the cut to Japan’s corporate tax rate could boost Japanese earnings per share by between 10 to 30 percentage points over the next 4 years.

Finally, Abe’s huge popularity, stable Government, control of both Diet houses and fading resistance to reform – eg farmers, who have been strong resisters of allowing a more efficient agricultural sector, now have an average age of 70 – means the reforms have a strong chance of success.

Good reason for optimism on Japan

Japan will not grow as fast as China as it is already a rich country and the success of Abenomics should not be judged mechanically by the 2% inflation and growth targets (as they are just lights on a hill). But when assessed broadly there are good reasons to believe Japan is throwing off the malaise of stop start growth and deflation seen over the last 20 years: the BoJ is doing all the right thinks to entrench inflation, the longer term reforms it is introducing are broad based and Abe appears to have the support required to deliver.

Implications for investors

There are two major implications for investors. First, a reinvigorated Japan is positive for Japanese shares. After a 57% gain last year, Japanese shares had become overbought and due for a correction, which is what we have seen this year with a 15% fall into April. Having worked off the excess, Japanese shares are now attractive again. While the boost to Japan’s economy and share market last year was driven more by monetary easing, economic reform looks likely to be a major driver over the longer term.

Second, Japan is still the world’s third largest economy, so stronger more sustainable growth in Japan is positive for the global economy at a time when Europe is gradually recovering and the pace of growth in the US is picking up. This in turn is positive for global shares generally.

Japan and Australia

Japan takes 16% of Australia’s exports and is our second largest export market, so a continuing exit from deflation and stronger growth in Japan is positive for Australia. This also comes at a time when a free trade deal with Japan is being signed. While the trade deal does not change the near term growth outlook for either country, its benefits will accrue over time. The main beneficiaries are beef and dairy farmers, service industries (such as finance) and consumers as tariffs on imported cars, household and electronic goods from Japan fall to zero.

Shane Oliver, Head of Investment Strategy & Chief Economist

———

Important note: While every care has been taken in the preparation of this document, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) make no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This document has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this document, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This document is solely for the use of the party to whom it is provided.

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Nikko AM adjusts its global equities position.

An overweight stance on global equities that lasted for over two-and-a-half years has been cut to neutral by Nikko Asset Management’s Global Investment Committee (GIC), the company announced yesterday. Nikko Asset Management is a related entity of Tyndall Investment Management Limited. In confirming the provisional decision made in early March, the Tokyo-based asset manager cited the following concerns:

1) Heightened fear of geopolitical risk,

2) Accelerating deterioration of China’s economy and financial system,

3) Subpar US and Japanese economic growth, and

4) Little room to re-rate Western equity valuations and continued deterioration in earnings estimates.

“We believe equity valuations have peaked and that markets will trade nervously going forward. On top of that, unsettled geopolitics make us uncomfortable and the fallout from China’s reform efforts could cause some shocks,” said John F. Vail, Chief Global Strategist and GIC Chairman. “In a few markets we expect equities to do well, but against the tunnel of uncertainty looming out there—and given the slim difference between our bond and equity return forecasts—we feel a neutral view on global equities versus bonds is warranted.”

Vail expressed his views in the firm’s most recent Evolving Markets research report. Elsewhere in the report, analysts reported that 2013 fourth-quarter data on overall corporate profits in Japan (including unlisted companies) was very positive, with a record-setting quarter-on-quarter increase in the pretax recurring profit margin, while the four-quarter average hit a new high of 4.6%.

The report concludes that several other indicators confirm that Abenomics is working much better than the pessimists suggest.

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China’s shadow banking more important than US Fed: Nikko AM

The impact of bad debts in China’s shadow banking system is likely more important to the global economy than Fed policy, latest research from Nikko Asset Management (Nikko AM), a related entity of Tyndall Investment Management Limited (Tyndall AM) shows.

Unfortunately, due to a lack of transparency and the extremely complicated system, even well-informed global investors cannot grasp the true nature of China’s financial difficulties. Several property trusts have already defaulted, but with rising land prices and generous credit, these have managed to be “worked out;” Recent defaults in the mining and industrial sectors with questionable collateral will likely have more serious repercussions, however.

“Local governments have less capacity to offer rescues considering their own funding issues, and so we expect that many more defaults are likely this year,” said John F. Vail, Chief Global Strategist at Nikko AM’s Tokyo head office. “Meanwhile, other efforts to increase regulation of the shadow banking sector are bound to reduce liquidity, especially to troubled borrowers, and this has some possibility of accelerating into a more serious credit crunch. Thus, we have long been cautious on Chinese equities and despite low valuations, we continue to believe that corporate profit margins will be under pressure and that bank earnings understate the true problem of bad debts.”

In other findings, iron ore is expected to fall in price from its current price level of around $130 per ton towards $110-$120 per ton by 2018, as a result of increased supply from Australia and Brazil. As a key component in steel products, demand for iron ore has surged as a result of China’s ongoing urbanisation process. The inability of iron ore producers to increase supply incrementally has led to a quadrupling of the iron ore price over the past 10 years.

“Looking forward to 2018, assuming the forecasted supply comes to the market, this should have the impact of reducing the iron ore price by around $20 per ton,” said James Eginton, a research analyst at

Nikko AM’s subsidiary, Tyndall AM in Australia. “Thus, the outlook for steel makers has begun to brighten with the potential for margin expansion and improved financial performance over the longer term.”

In Japan, inflation is moving strongly upward, with pipeline inflation rising 0.8% month-on-month in December (3.3% year-on-year). There are also strong signs that this is flowing through to retail prices, with the goods portion of the Consumer Price Index rising 0.7% month-on-month in November and up 5.4% on a 6-month annualised basis.

In an update to our previous report on the Abenomics Wealth Effect, the latest data from the Bank of Japan shows that ¥84 trillion ($805 billion) of household financial new worth (excluding real estate) was created in the 12 months to September 2013, summing to ¥1.24 quadrillion of net financial assets, a record high. The impact of more wealth on consumption will be key to the success of Abenomics.

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Dominic Rossi

Global stock markets had another stellar year in 2013 as the S&P 500 Index notched record after record. Investors are likely to remain well disposed to equities in 2014 due to the same underlying reason – the prospect of sustained economic progress in the US.

Indeed, the US economy is as healthy as it has been in the past 20 years thanks to the structural improvements in its fiscal and trade deficits. In 2009, the US fiscal deficit was 10% of GDP, or about US$1.5 trillion (A$1.7 trillion). By 2015, this shortfall is forecast to be only 3% of GDP, which is comparable to trend GDP growth and allows the US to stabilise its debt levels. For the first time in 30 years, the trade position has improved during a time of economic growth and the reason for that is shale energy. These narrowing deficits have helped to stabilise the US dollar, which is one of the reasons commodity prices and some emerging markets have been under pressure.

The rally in the US stock market has helped restore the confidence and net worth of consumers. One important point to recognise about the US stock market is that it is a source of economic strength as well as an outcome of it. A hefty chunk of US wealth is invested in the stock market and, despite wealth inequalities, a rising stock market helps the economy. We now have the prospect of the US economy growing at a sustainable 3% real rate in a low-inflation environment, which means the Federal Reserve can afford to prune, or taper, its asset buying. This is a broadly supportive environment for developed world equity markets.

A further rerating of equities is possible but there is less potential for earnings growth to take stock prices higher. The US is the place likely to deliver the best earnings growth, but generally stock prices will rise faster than profits. It follows that valuations would move higher and investors should be aware that there is some risk that equities could become expensive and prompt corrections.

Worrying Europe

While investors can expect the US economy to expand, nominal economic growth will remain low. As inflation is generally tame across major economic areas, the logic for tighter monetary policy is simply not there. Discussions about the rapid normalisation of rates appear overdone. Real interest rates are likely to remain negative for some time given the debt dynamics of developed economies. Public debt levels today are higher than they were in 2008 due to the transfer of debt from the private to the public sector.

Despite the pressing need, the tapering or the unwinding of quantitative-easing support will be a focus in 2014. Once tapering begins in the US, it will present a bigger challenge to Europe than it does to the US because of the deflationary dynamics in Europe. Given that the US labour force participation rate is historically low – having fallen to a 35-year low in 2013 – and real incomes are not growing in the US, there is little to prompt the Fed to taper. It would be best to see 3% growth and material improvements in employment before tapering begins.

Although we’ve seen some incipient signs of recovery in Europe, this should be viewed as a statistical event coming off extremely low levels of growth. There is little inventory in Europe, so even a slight shift in demand affects industrial production and growth. A modest cyclical improvement should not be confused with a structural recovery, as the preconditions are not yet in place for the latter to occur.

This broader structural adjustment process is expected to persist for another two or three years. While there has been some progress, such as with unit labour costs in the peripheral countries, it has come with high social costs and there is still the risk that Europe faces a deflationary future given government policies. An inflation rate of close to 0% is not inconceivable next year. Nominal economic growth could thus amount to around 1%. Given that 10-year government bonds are in the region of 4.1% in countries such as Italy, the debt problem is worsening. Countries need primary surpluses just to even out the compounding interest effects. This makes it hard for Europe to grow out of its debt problems. Investors can expect some form of debt default (via rescheduling or restructuring) sooner or later in the eurozone. The key weakness for Europe’s equity market remains an undercapitalised banking system exposed to peripheral sovereign debt risk. Our research shows that while the strong banks have become healthier, the weak banks are in worse shape.

The improvement in European equity markets seen thus far has been largely driven by rebounding or economically sensitive areas with low returns on equity such as Greek banks. This is not the kind of rally to get excited about. The euro at its current level also represents something of a headwind to further progress. Valuations remain attractive, however, and half of the stocks in the European market have a dividend yield above the yield on credit, where yields are close to historic lows.

The better placed

In Japan, investors are waiting for evidence of Prime Minister Shinzo Abe’s commitment to his third arrow of structural reform. The equity market in Japan tends to be policy driven. The first two arrows of Abe’s radical economic program – fiscal spending and monetary stimulus – should lead to faster in GDP growth in the next 12 months. Against this backdrop, there is room for Japanese equities to move higher. But whether this rally will turn into a multi-year bull market is another matter. Delivering on the third arrow is the key and this requires some bold policy adjustments. Japan’s long-term real growth rate will not increase unless the workforce expands or productivity improves. There are two routes to boosting the workforce; increasing female participation rates, or immigration; the latter is an unlikely option.

The stable-to-stronger US dollar is putting downward pressure on commodity prices and, by extension, some emerging markets. Emerging markets now require a more nuanced strategy that recognises the divergent drivers within the emerging world. From 2003 to 2007, the rising tide of China and the weaker US dollar/strong commodity prices lifted many emerging countries. We are in a different environment now where the underlying heterogeneity of emerging markets has reasserted itself. Some markets will stumble, some will thrive.

In my view, emerging markets must turn away from export-led economic models and embrace structural reform. Those that do, such as China, should do well while those that do not may face headwinds. It is clear that emerging markets can no longer rely on the benefits of a weak US dollar and elevated commodity prices.

In terms of risks, the evolution of the credit cycle in China is a worry given the lack of transparency surrounding the country’s financial system. It’s clear that credit creation in China has outpaced economic growth for some time and the country’s debt is now equal to about 200% of GDP. In a country that does not have mature western-style financial markets, the extent of the debt compared with the size and experience of the financial system is a concern. The question is how a country like this could deal with deleveraging. Ultimately, investors can expect a lower rate of economic growth in China due to these challenges.

Over the past decade, commodity-producing nations prospered and investors rerated sectors and stocks connected to hard assets such as metal miners and steel companies. At the same time, intangible assets were devalued. It’s likely that we will see a rerating of companies with intellectual property in healthcare, technology and finance. These sectors are the ones that will lead stock markets.

Within pharmaceuticals, for example, we are on the verge of major therapeutic breakthroughs in areas such as oncology. In IT, internet companies remain innovative and valuations look cheap. The telecoms sector looks likely to be the beneficiary of M&A activity, especially in Europe, where regulators may take a positive view of any consolidation that increases capital investment. Lastly, while regulatory pressures plague financial services, there is scope for valuations to re-rate from low levels over the next few years.

by Dominic Rossi, Global Chief Investment Officer, Equities at Fidelity

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Neuberger Berman’s release its latest views on equities, fixed income and alternatives.

Managers and strategists at global investment manager Neuberger Berman envision positive momentum across many asset classes in 2014, as the global economy stabilises and generates moderate growth, according to Solving for 2014, the firm’s third annual outlook across global equities, fixed income and alternative investments.

As the investable universe has grown—across borders and asset categories—Neuberger Berman’s focus has broadened as well. This year’s edition is deeper, covering more ground than previous issues, reflecting the market’s increased diversity and the firm’s broad perspective.

The outlook provides Neuberger Berman’s views on equities, fixed income and alternatives, all on a global basis, and capitalises on the fundamental research of its portfolio managers and analysts.

“From an economic perspective, things are improving across a number of major economies,” said Joseph Amato, President and Chief Investment Officer of Neuberger Berman.

“As the Fed and other central banks adjust their approaches, investors should remain alert. Inflation trends remain moderate and we do not expect a significant uptick in rates this year. These shifts in policy merits close attention as investors adjust portfolios to capitalise on the improved growth and somewhat tighter monetary conditions.”

In equities, Mr Amato anticipates continued earnings growth this year tied to modest operating leverage as developed economies pick up.

In fixed income, investors can likely expect slow and steady growth and the potential for rising rates, said Brad Tank, Chief Investment Officer, Fixed Income.

“In my view, we’re probably in the middle innings of this growth phase in the US,” Mr Tank said.

“Things are getting better, but not rapidly. For the coming year, we anticipate a relatively benign growth environment, with continued momentum in the US, a modest acceleration in Europe and an ‘Abenomics’-driven recovery in Japan, offsetting China’s slower growth trajectory.”

An improving economy should lead to more private equity buyout activity, according to Anthony Tutrone, Neuberger Berman’s Global Head of Alternatives.

“At this point, we haven’t gotten to a major acceleration in buyouts, but we believe deals will begin to pick up,” he said.

Alan Dorsey, the firm’s Head of Investment Strategy and Risk, said a key issue for 2014 is achieving incremental return—whether through capital appreciation or additional yield—mindful that return outlooks have gradually shifted downward while interest rates remain extremely low. Alternatives are one key area that has gained traction, but another particularly important one from a portfolio allocation standpoint is emerging markets, he said.

“As investors enter 2014, improving global growth combined with shifting monetary policy are creating a nuanced environment, with obstacles but also opportunities,” said Paul O’Halloran, Managing Director, NB Australia.

Download Solving for 2014 here.

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