China’s surpluses are declining and therefore trade data for many other economies are deteriorating. At the same time, many of the EM economies have gone through a tremendous boom in recent years, driven by their previous success story and large capital inflows. As I outlined in the second quarter of last year in my piece “Butterfly Effect,” we have witnessed many years of a virtuous cycle. The inflow of capital revalued those currencies, and while many central banks intervened to dampen the revaluation, the liquidity thereby created fueled a domestic investment and consumption boom. It was a great success story leading to a credit and real estate boom of large proportions virtually everywhere. In the last five years, Hong Kong real estate has doubled in price, Singapore’s has increased by 70% and China’s has more than doubled. It was felt throughout the whole Asian region and also in selected EM economies in other parts of the world. Of course, they and many Western commentators interpreted this as “normal” because they all believed clocks tick differently in those economies. While some may have better demographics and less government debt, they have created private sector credit bubbles of historic proportions. Most importantly, they are exposed to cycles as everybody else.
In the currency arena, the U.S. Dollar has been firming for quite some time against virtually all others except the euro family of currencies. I expect the stronger dollar trend to continue despite some interest rate hikes in selected emerging economies. Those economies have to be rebalanced through a full-fledged balance of payment crisis that does include a recession. While the extremes of last week may lead to a temporary pause in EM currencies, I expect them to continue weak later.
The euro is a deflation currency with the same characteristics of the Japanese yen until the regime change in the country of the rising sun. We see chronic current account surpluses, a stagnating and aging population and a deflationary economic policy mix with economic stagnation. This condition must change, similar to Japan in late 2012. We don’t know when, but further disappointments this year will create rising stress in the euro zone. The recent change at the ECB of withdrawing the sterilization of bond purchases amounts to some easing and a weakening of the euro; however, it will not be enough to improve the economy. Hence, we see the upside of the euro against the U.S. unit as very limited and expect a weaker euro in coming months and lasting well into next year, as the ECB will at some point be forced to do a lot more.
The big surprise for the world will in our view be a temporary strengthening of the yen. The world is short yen, as it has been used as a funding currency that declines in value and costs extremely low interest. Moreover, the Japanese have outlined their goal of weakening the currency to end deflation. The economy will do well up until April 1, when the VAT will be hiked by 3%. This will lead to CPI inflation of close to 4% while wages will only be raised by 1%-2%, leading to an income shortfall in real terms. Hence, the economy will most likely be quite weak in the 2nd and 3rd quarters. The Bank of Japan is aware of this and has recently stopped buying JGBs to make room for more aggressive steps later. Hence, I expect the world to be forced to cover their yen shorts, as Abenomics will look like a failure. We expect the Japanese to launch another stimulus program, including aggressive monetary easing, that will most likely start sometimes in the second half and trigger the next phase of yen weakness, but only after a temporary correction that could amount to approximately 10% from recent extremes versus the U.S. dollar and more versus other major currencies."