In our latest House View, "2024 Q2 Global Economic Outlook (I)," we delved into the economic trajectories of the United States and Europe during the first quarter of 2024 and our outlook for the second quarter. We believe that the “last mile” of the inflation fight for the Federal Reserve will be challenging and expect the Fed to start cutting interest rates in the third quarter, with two rate cuts in 2024. We also remain optimistic about the performance of the US stock market this year. On the other hand, due to the lack of growth momentum in Europe’s economy, we expect that the European Central Bank would begin its rate-cutting cycle earlier than the Fed, possibly by the end of the second quarter of 2024. Today, we will further share our views and insights on Japan and China.

Japan – Entering Rate-Hiking Cycle, Weak Yen, Favor Japanese Bank Stocks

Given that Japan's inflation has exceeded 2% for 22 consecutive months, and the results of wage negotiations during shuntō (spring wage offensive) exceeded market expectations, the Bank of Japan officially ended its seven-year negative interest rate policy in March 2024, raising its interest rate from -0.1% to 0-0.1%. At the same time, the Bank of Japan abandoned its yield curve control policy implemented since 2016, marking a shift from its decade-long ultra-loose monetary policy to a new phase of rate hikes. However, the market generally thinks that the Bank of Japan's Governor, Kazuo Ueda, has adopted a dovish stance, reflected by his speech at BoJ’s March meeting, leading to a further decline in the USDJPY exchange rate, hovering around the level of 151.

Facing the continued weakness of the yen, policymakers in Japan have repeatedly hinted at possible intervention in the country’s exchange rate through public speeches. We observed that recent comments from the Bank of Japan indicate that policymakers are closely monitoring the yen's exchange rate and are alert to any further depreciation. While verbal intervention is not uncommon among central bank policymakers, we believe that Bank of Japan officials may strengthen their efforts and adopt more forceful measures to support the yen, such as selling dollar reserves in open market operations. The last time the Bank of Japan intervened in the market was in October 2022, when it sold over 40 billion of its dollar reserves. According to Goldman Sachs, the Bank of Japan currently holds approximately 1.75 trillion in dollar reserves, making it fully capable of conducting interventions similar to the scale of 2022 to prevent further depreciation of the yen.

However, we expect that the changes in market expectation regarding the number of rate cuts and the start of the rate-cutting cycle by the Federal Reserve will exert pressure on the yen in the short term, pushing USDJPY above 150. According to J.P. Morgan, changes in the interest rate spread between US and Japanese government bonds accounted for 80% of exchange rate movements over the past two years, and will continue to be the main driver of USDJPY in 2024.

Despite the close monitoring of BoJ’s policymakers on the speed of yen depreciation and their potential interventions in the foreign exchange market, we believe that reversing Yen's short-term weakness appears challenging. Additionally, between safeguarding government bonds and foreign exchange, we believe that the Bank of Japan still prefers to keep the long-term Japanese bond yield at a low level, in order to ensure that its ultra-loose monetary policy of the past decade can be continued and the government as well as private sector to continue accessing financing at low rates. Moreover, considering that there is a chance for further narrowing of the US dollar's interest rate cuts, the interest rate spreads between Japan and the US will solidify the yen's attribute of carry trade and put pressure on any appreciation of the Yen. Therefore, even if the Bank of Japan hikes rates, without a corresponding increase in its real interest rates, the Yen would require a weakening of the US dollar in order to gain momentum.

Looking ahead, the Bank of Japan has not yet revealed any specific timeline for the next interest rate hike. However, given significant rise in inflation and wage adjustments, investors anticipate another rate hike to occur in July or October within this year. Governor Ueda confirmed on Friday in parliament that monthly net purchases of Japanese bonds would be maintained at 6 trillion yen.

In the long term, given that the interest rate differential between Japan and the United States is likely to further narrow by the end of 2024, we predict that USDJPY at the end of 2024 will be within the range of 138-142. It is worth mentioning that if the Fed's interest rate cuts this year fall short of market expectations, and the Bank of Japan maintains its current dovish stance, the Yen may lack the necessary upward momentum for further appreciation. In this case, USDJPY may fluctuate around the 145 level by the end of 2024.

As for the Japanese stock market, the Nikkei 225 index has recently fluctuated within the range of 39,000 to 40,000. We believe that two structural changes - the transition of the Japanese economy from deflation to inflation, as well as the gradual implementation of corporate governance reforms aimed at increasing shareholder returns - are the main factors driving the strong performance of the Japanese stock market this year. These changes have attracted substantial foreign fund flow to the Japanese market and boosted investors' confidence in the Japanese stock market.

We believe that due to the weakness of the yen and the strong performance of the US economy, the profitability outlook for Japanese companies will continue to improve. Therefore, we recommend investors to keep an eye out for opportune moments to increase exposure to the Japanese stock market, such as when officials from the BoJ verbally intervene to halt the depreciation of the yen, or when the USDJPY exchange rate falls below 150. Consistent with our views at the end of last year, we remain bullish on Japanese banking stocks, particularly Mitsubishi UFJ Financial Group (8306.JT), Sumitomo Mitsui Financial Group (8316.JT), and consumer staples stocks such as 7-Eleven (3382.JT). Companies in these sectors are expected to continue benefiting from the narrowing interest rate differential between Japan and the US in the future, offering attractive returns for investors.

China - Economic Slowdown, Pending Structural Shift, Remain Cautious

On March 31st, China released its latest official PMI. The index rebounded to 50.8, marking the first expansion in six months and the highest level since a year ago. Following the data release, the Shanghai Composite Index rose by 1.19%, and the Shenzhen Component Index increased by 2.62% as of Monday's close. The Hang Seng Index also gained momentum, rising approximately 2% on Tuesday. Coupled with the previous positive data, such as the February Consumer Price Index (CPI) turning positive, we have sufficient reason to believe that the near-term downside risks to China's economy are diminishing.

While the improvement in economic data has restored some confidence among investors, the structural issue for the economy remains. It is worth noting that the recovery of China's economy is primarily driven by consumer spending during the Chinese New Year and fiscal policies directed mainly towards funding infrastructure projects. However, the private sector, especially the real estate industry, has yet to recover and regain investor confidence. Considering the uncertainties in the economic structural shift and weak government support, we believe investor confidence in China's economy will not be restored in the short term. Therefore, the performance of the Chinese stock market is expected to lag that of the United States and Japan.

In our China economic outlook released at the end of last year, we highlighted two major issues facing China: insufficient liquidity and a downturn in the property market. The Fed's decision to maintain the federal funds rate in the elevated range of 5.25% to 5.5% has fueled persistent interest rate differentials between China and the US, driving carry trades. We expect the challenges of capital outflows and liquidity shortage to persist, leading to a weakening of the renminbi within the range of 7.1 to 7.3. The robust economic data has caused a delay in the US rate cuts the market previously priced in, while the economic slowdown in China only allows for flat or lower interest rates. Even if the Fed decides to cut rates, PBOC is likely to follow its step to stimulate the economy. Therefore, we believe that the elevated China-US interest rate differential will persist, resulting in a continued depreciation of the RMB. Considering that a moderate depreciation of the RMB would help with exports and growth plus PBOC's emphasis on maintaining a stable RMB, it is likely that the RMB will experience a slight depreciation without breaking the 7.3 threshold.

Furthermore, the real estate sector, which accounts for approximately 25% of China's economy, has yet to show significant signs of improvement. The latest data on the real estate industry for January and February revealed a year-on-year decline of 9.0% in real estate investment, a decrease of 20.5% in floor space and a 29.3% drop in sales revenue for newly built commercial buildings. Some economists estimate that it will take more than five years for China to consume the existing and under-construction housing inventory. Despite a series of supportive measures from the government, the lingering real estate crisis has affected consumer confidence and weighed on the overall economy. As our previous report indicated, many of the emerging issues are structural in nature, and the Chinese government plans to address them strategically. Therefore, the process will take time and remain challenging. As the market needs to see strong signs of recovery or significant economic engines to regain its confidence, we maintain a cautious attitude towards the Chinese market in the short term.

In China’s stock market, we favor fundamentally sound companies with stable business models, such as Alibaba, JD.com, Tencent, Meituan, and Pinduoduo. The recent release of their Q4 2023 and full-year financial reports has demonstrated their robust financial health and ability to sustain stable growth. Yet, their valuations remain relatively low. The lack of investor confidence in the Chinese market will continue to constrain short-term stock valuations in China. Since the beginning of this year, state-owned funds, such as Central Huijin Investment, have entered the market in an attempt to boost the stock market through ETF purchases. However, the stock market's response has been lackluster, experiencing a brief uptick followed by a retreat due to a lack of momentum. Still, with the support of these state-backed funds, we are confident that the downside risk in the stock market is limited, and the Hang Seng Index will not fall below 15,000 again.