Markets facing bleak outlook both economically and geopolitically

Optimism about the US central bank ending its monetary policy tightening and reversing course by early next year have all but vanished. With core inflation data coming hot as we have been anticipating, rising prospects for the US benchmark rate going above 4% level and staying there for at least another year have led to another big sell-off in equities. 

Indeed, concerns about US economic growth, clearly reflected by the continued inversion of the yield curve, is now spilling over to deep cyclical stocks in sectors such as steels and shipping which have come under heavy selling pressure more recently. In this environment, we don’t think Japan’s stock market which is highly geared to economic sensitive segments can continue outperforming the other majors in local currency terms.

This week’s Fed meeting where expectations are for another sizeable rate hike and tough talk underlining policy makers’ resolve to bring inflation under control is unlikely to bring much relief for investors. Meanwhile, BOJ’s continued policy errors will be laid bare in its upcoming meeting as weaker yen is raising import bills while Japan’s core inflation rate is climbing towards 3% level (and in our view will head much higher next year). 

As we have long argued, unless BOJ pivots away from its yield curve control now long abandoned by other central banks, not only the yen is likely to weaken further, but the likely higher inflation rate in Japan will be adding more pressure on the bank to shift course. However, given BOJ governor’s insistence that this cost push inflation is transitory, such a change in policy is likely to be only implemented once he resigns.

We also think that Japan’s MOF has left itself little room and is likely to be forced to intervene in the currency market should the $¥ rate test 145 level again. Although the initial near term impact of any intervention will likely prove more meaningful, we think the yen selling will intensify again and the follow-on interventions will prove more futile. 

The geopolitical picture looks equally disheartening as tensions between US and China remains highly elevated while export bans to China of key technologies continues to broaden. This as we have explained since last year could have far reaching negative implications for our market as it is likely to engulf many Japanese firms that supply China with high tech materials and equipment.

Moving on to Eastern Europe where war is still raging, Ukraine’s recent successes in pushing back Russian forces from its occupied territories seem to have raised the risks of Putin resorting to extreme measures such as blowing up Ukraine’s Zaporizhzhia nuclear power plant or even ordering tactical nuclear strikes to try to turn the tide. With Russia’s ultra-nationalists becoming increasingly critical of Putin’s “half-hearted war”, arguing for a more forceful response, we fear that risks of the war escalating and dragging NATO directly into battle has risen considerably.