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Malaysian Reserve
5 days ago
- Business
- Malaysian Reserve
Neutral on Europe, but bright spots remain
The need for precautionary savings has increased amid lingering uncertainties by IFAST RESEARCH TEAM THE European Union (EU) has recognised the urgency to pursue military independence amid US President Donald Trump's withdrawal of security support from NATO, prompting a surge in defence budgets across the region. At EU level, president Ursula von der Leyen announced the 'ReArm Europe' plan, a fiscal stimulus of €800 billion (RM3.84 trillion) over four years, aimed at raising defence spending from 1.9% to 3% of GDP. Meanwhile, Germany, traditionally reluctant to take on debt, has exempted defence spending from its fiscal cap and introduced a €500 billion infrastructure and defence fund, marking a significant policy shift. Together, these measures have bolstered sentiment across Europe, with the eurozone manufacturing Purchasing Managers' Index (PMI) rising to a 27-month high in April, indicating early signs of a bottoming-out in the industrial sector, further supported by improved industrial production. Inflation has eased considerably to 2.2% in April from its previous highs of 10.6%, largely driven by a decline in energy prices. Service inflation has also moderated, from 5.6% to 3.9%, reflecting broader disinflationary trends. With inflationary pressures moderating, the European Central Bank (ECB) is now on track to further cut rates, following seven consecutive cuts, thereby lowering borrowing costs and supporting economic recovery. Economic Data Points to Tentative Recovery Despite the easing of inflation and the improvement in consumer purchasing power, consumption is yet to show a convincing recovery. Retail sales growth remained tepid in the previous months, although the latest March data came in somewhat stronger than expected. Nevertheless, the broader trend still points to cautious household behaviour, with the savings rate remaining well above the long-term average. The need for precautionary savings has increased amid lingering uncertainties — from the Russia-Ukraine war and ongoing trade tensions to the re-election of Trump, which has reignited geopolitical concerns. European natural gas prices have declined significantly from their 2022 peaks, alleviating one of the biggest post-war cost burdens for manufacturers. Nonetheless, prices remain above the historical averages, continuing to weigh on the region's corporate competitiveness. Manufacturing PMI has stayed in the contraction zone, whether the recent rebound marks a true turnaround or only a tentative recovery, will take further time to prove. Threat of Tariff Impact on Exports Adding to the uncertainty, escalating trade tensions with the US pose an additional risk to Europe's growth outlook. The US is the largest exporting destination for EU goods, accounting for over 20% of the bloc's exports. Following recent US tariff measures, the average tariff rate imposed on EU products could rise sharply from 1.47% to 15.2%, according to Bruegel. As a significant share of the EU's GDP is tied to exports, the materialisation of these tariffs jeopardises Europe's growth outlook. However, the EU retains several cards to play in retaliation against these measures. As one of the US' largest trading partners, the EU's countermeasures could contain or even reverse some of the US' tariffs. The EU has already responded with targeted tariffs impacting up to US$13.5 billion (RM57.34 billion) worth of US exports, carefully focusing on goods from Republican-leaning states — such as soybeans — in an effort to pressure Trump's core political base. If the situation deteriorates further, the EU has even stronger options, including tightening regulations on US tech firms operating within the bloc. Given that Europe represents one of the largest markets globally for both the products and services of American technology giants, any measures targeting these companies could strike at a core pillar of the US economy. Nonetheless, the EU remains reluctant to escalate the conflict aggressively, maintaining a preference for a negotiated solution despite the confrontational stance from Washington. More importantly, as the US pulls back from global trade, other countries are likely to diversify their trading relationships and form new alliances. In this context, Europe could play a more prominent role in global commerce. This shift may also support the euro, particularly if it gains traction as a currency for invoicing international trade. A more widely used euro would, in turn, help reduce borrowing costs across the euro-area. Trump's challenges to independent institutions — such as the Federal Reserve (Fed) and universities — as well as to the rule of law, have made Europe's institutional framework appear more stable by comparison. The EU's commitment to the rule of law, with its system of checks and balances, remains a foundational strength. Moreover, Europe continues to show openness to trade and foreign investment. Widening Innovation Gap Between Europe, US However, much still hinges on long-overdue reforms, including the development of larger and deeper capital markets. Europe is falling behind in the artificial intelligence (AI) race, with the largest advancements in chips, language models and AI applications dominated by US companies. A key factor is Europe's insufficient research and development (R&D) investment. The gap in R&D spending as a percentage of GDP is widening between the EU and the US, driven by Europe's less developed venture capital market. In 2023, US venture capital funding was three times larger than Europe's, attracting more AI start-ups to the US for financing. With limited access to venture capital and government funding, European start-ups are often forced to rely on bank loans or seek capital abroad, stifling innovation. Unless substantial progress is made in capital market integration, Europe risks falling further behind in productivity growth compared to other major economies. This challenge is compounded by an aging population, which not only reduces the labour force but also exerts additional pressure on productivity. Key Takeaways While macro indicators are yet to show a convincing recovery, select sectors offer pockets of resilience and opportunity. Home to numerous multinational pharmaceutical and medical device companies, Europe's healthcare sector stands to benefit from the surging global demand for weight-loss and diabetes treatments, particularly those developed by Novo Nordisk. Key catalysts include projected record-high sales of weight-loss drugs and advancements targeting higher weight-loss efficacy, both of which could drive strong stock performance. Another sector that could deliver stronger performance is technology. Though tech is a relatively small sector in Europe, some key companies play a critical role in their respective field. The views expressed are of the research team and do not necessarily reflect the stand of the newspaper's owners and editorial board. This article first appeared in The Malaysian Reserve weekly print edition
Malaysian Reserve
22-05-2025
- Business
- Malaysian Reserve
Time to relook at Japan
Recent softness in profits appears more cyclical than structural, likely driven by a cautious pullback in biz investment by IFAST RESEARCH TEAM NIKKEI 225 staged a strong V-shaped recovery following its sharp dip on April 2, Liberation Day, yet, there is still a loss year-to-date (YTD) as the falling US dollar/Japanese yen pair, in large due to relative weakening of the US dollar and tariff-induced safe haven flow into the yen so far. The Nikkei 225 (price-weighted) saw a steeper decline, while the cap-weighted Topix Index, especially large exporters (Topix 30) and small-cap stocks (Topix Small 500), shows a milder impact despite yen rallied YTD, suggesting the still solid fundamentals in the Japan market. Has Japan taken the hit? We have yet to see a significant deterioration in growth momentum, with corporate earnings remaining resilient despite signs of moderation. The recent softness in profits appears more cyclical than structural, likely driven by a cautious pull-back in business investment as firms anticipate weaker demand and brace for potential tariff-related disruptions. As shown, operating profits in Japan's manufacturing sector are normalising after an outsized contribution during the post-Covid-19 recovery. While the absolute trend remains steady, the sector's profit share is reverting toward its long-term average, signalling contin- ued earnings growth, albeit more tempered and increasingly priced for future external headwinds. BOJ Sees Less Room to Manoeuvre Markets are again showing signs of a 'buy the rumour, sell the news' pattern. The recent selloff sparked by tariff headlines and US President Donald Trump's tweets appears to overshadow macro positives, driving volatility and limiting the Bank of Japan's (BOJ) flexibility to act boldly. In this fragile environment, the central bank is likely to proceed cautiously, with a calculated approach to avoid spooking markets further. Japan, though not the centre of the turbulence, has not been spared. Panic selling has dragged even fundamentally strong sectors like exporters and financials lower, pressured by the yen's sharp gain and fears of forex translation losses. We expect two more rate hikes this year and bring interest rate to 1%, having pushed back expectations to July from May due to renewed tariff risks that rattled the inflation outlook. While some on the street expect the next rate move only in January 2026, being sceptical that hiking amid fragile sentiment and surging food costs surging could risk a sharp yen rebound and hurt the export sector. Macro data is not signalling urgency for rate hikes either. Headline inflation appears overstated, driven largely by a near doubling in rice prices since March last year amid tight supply. This has delayed the recovery in real wage growth, which could hardly turn positive in the near term until food cost pressures ease and government incentives help. That said, inflation progress is encouraging. Consumer prices have passed the 3% mark, a positive development after being stuck in the upper 2% range for months. This shift was initially helped by the roll-back of government utility subsidies last June. However, with those subsidies now partially reinstated and energy prices weakening, inflationary pressures may ease again in the near term, offsetting partially the elevated food cost. On the wage front, momentum has stalled moderately after February's bonus payouts, as most corporates are playing it safe. Many are reluctant to boost base salaries or commit to productivity-enhancing investments, opting instead to adopt a wait-and-see stance. 1Q25 Earnings Look Steady While we expect upbeat headline results for the first quarter, the visibility into the coming quarters remains unclear. With US tariff policies still in flux, the financial year 2025 (FY25) guidance will be a key focus. Tariffs, US recession risks and yen strength all pose headwinds for overseas demand-driven sectors. As a result, we prefer domestic demand-focused names, which are more insulated from external shocks. Business conditions remain favourable for real estate, information and communications, trans- portation and logistics. Retail sentiment is rebounding. In manufacturing, confidence remains strong in heavy machinery, a sector often buffered by capex cycles and infrastructure projects. What the Tankan Survey Tells Us The March 2025 BOJ Tankan survey offers a detailed snapshot of corporate sentiment. Sales expectations for FY25 slow to 1%, signalling caution amid global uncertainties. For recurring profit — a key metric in Japan akin to operating profit but slightly broader, where 2024 saw a significant upward revision from -4% to 2.6%, reflecting a surprising margin recovery. However, the 2025 plan flattens to just 0.2%, highlighting potential cost pressures and diminished pricing power. Margins are improving for FY24 (10.6% to 11.5% in manufacturing), but may normalise slightly in 2025. Net profit growth for manufacturing in 2024 is now projected at 6.8%, outpacing non-manufacturing's 1.2%. The green shoots in manufacturing suggest optimism that should tariffs ease, we may see further upward revisions that push FY25 growth into low single digits. Capital expenditure (capex) trends, however, reflect lingering caution. After a -2.3% revision to 2024 plans, total investment is still strong at 13.4%, though that growth moderates to just 3.1% in FY25. Software investment, while still healthy this year, is forecast to decelerate sharply next year, hinting at front-loading of digital capex amid tariff-related uncertainty. Impact of Stronger Yen on Japan Equities We see the potential for US dollar/ Japanese yen to test the 135 level by end-2025, supported by persistent safe haven flows amid a dimmer trade and growth outlook, as well as ongoing geopolitical tensions. While we expect Japan to deliver two additional rate hikes, the moves are likely to be gradual and measured to avoid triggering a sharp unwinding of carry trades. Assuming a conservative 5%-yen appreciation against the US dollar by end-2025 following a strong YTD gain of 10% to 142 (a simple back-test suggests a potential 14%), we estimate an earnings drag of -5.8% for the Nikkei 225. Roughly half of the pressure would come from the consumer discretionary sector (eg Toyota Motor Corp, Sony Group Corp, Fast Retailing Co Ltd, Honda Motor Co Ltd, Denso Corp) and the technology sector (eg Keyence Corp, Tokyo Electron Ltd, Fujitsu Ltd). To clarify, we adopt the non-tax-adjusted EPS impact of -5.8% as a more prudent estimate that captures the broader downside risks from both macro headwinds and currency. Given the export-heavy nature of Japan's equity benchmarks dominated by automakers, machinery and precision equipment, we believe that index earnings could suffer harder hit compounded by tariff-related pressures, slower global demand and sentiment-driven multiple compression. The higher-end estimate allows for a margin of safety in light of these layers of uncertainties. Stay Bullish on Japanese Equities Japan's macro environment remains compelling for investors who are committed to long-term investing. Small caps are worth another look, of which the United Japan Discovery Fund invests in domestic-oriented companies, hence less exposed to yen volatility and global trade shocks. In fact, small caps experienced shallower drawdowns during the recent selloff and could benefit from stable wage growth, resumed utility subsidies and soft energy prices, all of which support discretionary spending at home. The views expressed are of the research team and do not necessarily reflect the stand of the newspaper's owners and editorial board. This article first appeared in The Malaysian Reserve weekly print edition
