Naomi Fink, Chief Global Strategist at Nikko Asset Management outlines the asset manager’s recent Global Investment Committee session, and says despite volatile market movements, the committee sees a positive growth outlook for most major economies, with allowances made for heightened downside risks.
In August, the Global Investment Committee (GIC) held an extraordinary session to review the impact of recent volatile market movements, as well as the growing concerns over slower US growth. In summary, our conclusions were as follows:
• We maintain our central scenario for positive GDP growth in most major economies, although we see heightened downside risks to our US GDP growth outlook given recent softer-than-anticipated US data. We continue to anticipate range-bound inflation, with a gradual disinflationary trend in the US and Europe. Meanwhile, we expect reflation to continue in Japan and pick up in China.
• We continue to see the Federal Reserve (Fed) delivering at least the one interest rate cut in 2024, which we believe will help growth remain positive. However, we also foresee higher risks of a more pronounced slowdown in growth; this, in turn, could contribute to higher risks of the Fed engaging in multiple rate cuts in 2024 and early 2025.
• We maintain our view that Japan’s “virtuous circle” of wages and prices will remain intact, with growth likely to remain above potential and inflation expected to surpass the Bank of Japan (BOJ)’s 2% target over the immediate horizon. The yen, meanwhile, recouped some of its earlier losses faster than we expected.Combined with our outlook for upcoming Fed rate cuts, the BOJ’s resolve to normalise policy (albeit gradually) is likely to keep the yen moderately supported. Indeed, versus the dollar, we do not foresee the yen spending time back above 150. This may, in turn, bring some temporary volatility that impacts equity valuations, which could create buying opportunities. Meanwhile, there is some risk that the yen’s reversal may have some second-round effects on corporate earnings, albeit with a lag.
• We expect US earnings growth to remain positive over our outlook period but maintain our more conservative earnings outlook versus consensus estimates. Moreover, we foresee limited upside in valuation (P/E), unlike in Japan where valuations are less rich.
Global macro: increased downside risks to US GDP growth outlook
New developments in US GDP growth and inflation since Q2: In the US, following several substantial downward revisions to past data, the July nonfarm payrolls came in significantly softer than expected. The US unemployment rate also rose to 4.3% (although, importantly, labour participation rose). The Sahm rule1 was triggered, and some market participants began to fear that a recession was imminent, giving rise to some calls for 50 basis point (bp) Fed rate cuts within 2024. June’s core CPI cooled further while US manufacturing activity contracted in July by the most in eight months, weighed by subdued orders and production in addition to the largest ISM employment drop in four years.
However, there were also caveats to the weak data. Although consumer sentiment remains soft, average weekly earnings continued to expand in June, as did retail sales. Meanwhile, despite the softer June CPI print, the Fed’s favoured core PCE indicator failed to decelerate as expected in June.
Additionally, in spite of disclaimers by the Bureau of Labor Statistics that the weather (hurricane Beryl) had “no discernible effect” on the weak nonfarm payroll figure, the data appear to indicate otherwise. Most of the layoffs were temporary (with permanent job losses little changed) and the decline in job losses in the establishment survey was concentrated in transit and ground passenger transportation sectors, which were likely to have been influenced by the weather.
Moreover, the increase in the US unemployment rate comes amid steady growth in the US labour force (thanks to immigration) and a steadily increasing labour participation rate. As such, this decrease does not owe purely to a deterioration in employment.
GIC perspective: slower but positive growth trajectory intact while volatility contributes to downside risks
With inflation, though showing some signals of slowing, still above the Fed’s 2% target, we were reluctant to react to one month of soft US data. Meanwhile, several Fed speakers have since tempered expectations for aggressive easing, including multiple 50-bp reductions or inter-meeting cuts.
That said, we note the reaction of financial markets to the softer data with the VIX spiking to highs above 60 as speculative “carry trades” were unwound. While we admit that it may be somewhat circular to reference financial market turbulence as a harbinger of slower growth, it is worth noting that financial markets have been great contributors to accommodative financial and monetary conditions.
As such, we found it unwise to overlook downside risks to the economy should financial market volatility return and prove disruptive to growth. Therefore, we have downgraded our 25th percentile US growth estimates as outlined below, which also slightly impacts the median GIC estimates of US growth.
Japan equities: volatility, dollar yen impact temporary but non-negligible
New developments in Japanese equities since Q2: As the market re-rated the “carry trade”, the CBOE VIX index (a proxy for equity market risk over the next 30 days) spiked on 5 August to above 60 from below 20, after which volatility has slowly abated. The Nikkei 225, which is price-weighted and therefore volatile, saw three-month at-the-money implied volatilities (a slightly longer horizon measure than the VIX) surge above 37 on 5 August before slowly pulling back. The TOPIX, typically less volatile, also saw three-month at-the-money implied volatilities spike near 30 and then ease somewhat.
Japanese stocks were oversold (with TOPIX price/earnings ratios sinking to the mid-11 handle), and the decline became a good opportunity for companies to buy back shares and institutional investors to accumulate stock. The TOPIX index subsequently staged a comeback.
Early observations by sector: Financials and trading company stocks were the hardest hit amid the sell-off but domestic demand and defensive names (e.g. medical equipment) remained more resilient. Similarly, many cash-rich stocks, as well as firms investing in human capital and consequently experiencing increased productivity, have also remained robust. Meanwhile, the sell-off significantly affected semiconductor and auto stocks. The sell-off may have undervalued high dividend yield names, which could be poised for an eventual comeback.
GIC perspective: With volatility still higher than before the recent market shock, the rebound by Japanese stocks appears to be limited below prior highs. That said, earnings in the first quarter of Japan’s current fiscal year (FY24) appear solid so far. Signals of domestic demand, including both consumption and investment, becoming a stronger driver of growth continue to support Japan’s “virtuous circle”. Firms appear to retain pricing power even as real wage growth has turned positive. The outlook appears structurally sound for the longer-term, though near-term, we suspect that the impact of stock volatility as well as a stronger yen (which would impact firms with significant overseas revenue) may exercise an interim drag on earnings in some sectors. Although we remain positive on earnings growth overall, it is possible that we may see some sector rotation, allowing for domestic demand sensitive firms that have underperformed to date to catch up with those more driven by overseas revenues.
We continue to expect Japanese corporates to generate healthy single-digit earnings growth across the TOPIX, which represents the majority of our Japan equity investments. However, we foresee valuations being affected by potential ripple effects from the recent market volatility and carry trade unwinding. We estimate that the impact may last for three to six months. Additionally, there is a risk that a weaker dollar/yen could, with a lag, exert a downward pull on the earnings of large cap exporters with overseas revenues, particularly among Nikkei constituents.
Although we remain firm in our conviction that Japan’s structural recovery is likely to continue supporting Japanese equities, we acknowledge the possibility for an interim resurgence in equity volatility. The GIC is shifting from single valuation assumptions (P/E) in Japanese stocks to a guidance range for P/E. This is similar to our guidance range for earnings per share (EPS) guidance, with which we aim to capture probabilities between the 25th and 75th percentiles of consolidated earnings growth. We are also making modest adjustments to our EPS guidance ranges and adding 25th and 75th percentile indicators for Nikkei-listed large-caps.
Earnings guidance ranges: We foresee year-on-year (YoY) earnings growth for the TOPIX ranging between 3% and 8% YoY (excluding base effects adjustments) over the second half of 2024. We expect earnings growth to recover to between 4% and 11% in the first half of 2025, once near-term volatility abates and companies have adjusted to a mildly stronger yen. We foresee the Nikkei’s earnings range between 5% and 20% YoY for H2 2024 (excluding base effects adjustments) and between 5% and 19% over the first half of 2025, with a more lasting impact likely to be felt among large exporters and firms reliant on substantial overseas revenue. In the near-term, we anticipate an adjustment in YoY EPS growth in September, due mostly to the low base effects of September 2023’s EPS. We believe that in the September quarter of 2024 there will be a one-off adjustment in YoY EPS growth terms in order for annual EPS to be kept on a gradually increasing trajectory.
Valuation ranges: We expect price/earnings to show greater fluctuations than what we have observed very recently. This is due to the market appearing more vulnerable to swings as uncertainty over economic growth impacts markets. We are therefore expanding our P/E estimates from single assumptions to a range, estimating outcomes between the 25th to 75th percentile. We expect the Nikkei’s P/E range to fluctuate between 16 and 24 in H2 2024, followed by a range of between 16 and 25 in H1 2025. We anticipate an upward bias over time given ongoing structural transformation among Japan’s corporates, led by large caps. For the TOPIX, we foresee a range of 13-17x in H2 2024 and 13-19x in H1 2025, with a similar upward trend over time.
Implied price (indicative only): price trends to be driven by EPS and higher valuation over time
As we noted in our Q2 GIC Outlook, we have made changes to the GIC process. This includes more closely aligning our Outlook with the views underlying our portfolio investments and therefore providing indicative guidance ranges as opposed to point forecasts of index prices for indicators and indices. As a result, we have shifted to guidance centred on variables that are of interest to us as investors, including earnings growth and valuation. For the convenience of our readership, we calculate indicative prices as implied by our EPS growth (using Bloomberg’s “BEst” Earnings estimates of realised earnings per share for the base year) and price/earnings guidance ranges, for reference purposes only. Based on the guidance provided above, the implied index prices are as follows:
The lows within the range represent the lower end of our anticipated price fluctuations, which takes into account the combined effect of earnings impact and valuation shifts. The highs within the range represent the upper end of our anticipated price fluctuations.
1 The Sahm rule is a heuristic measure of determining whether the economy has entered a recession using unemployment relative to recent history. The Sahm rule compares the three-month moving average of the national unemployment rate to its low over the prior twelve months (with an indicative threshold of 0.5% above the prior 12-month low).
