When we look back, I believe history will say the seeds of the next crisis were planted in the fall of 2014. I thought it was going to be Europe that started the party, but instead Japan raised their hand and volunteered by starting the world’s next currency war – although you’ll never hear a leader or Central Banker call it that. The currency war that will unfold over the next few years will bring a whole lot of volatility and have the potential to create serious change in the world. In my last post I expressed my concern for many emerging market countries moving forward, and I can now confidently say it will be far beyond just the emerging markets.
Currency battles are always going on because of globalization. Since the world is so interlinked and every country depends on people from other countries to buy their products, the value of your currency is the quickest and easiest way to boost your economy. And because of this, politicians love to influence it. By weakening your currency, you make the goods you produce cheaper for the rest of the world to buy when compared to other countries that produce the same goods – your competitors. This short-term advantage will quickly boost sales and help your economy, but doesn’t address longer term issues like running your business efficiently (keeping costs low), and the regulatory and tax environment. This is why you hear politicians up in arms every time another country’s currency falls against the US dollar, screaming about “currency rigging and manipulation.” While everyone says they’ll play nice in the sandbox, in actuality they only care about their own economy at home, and this is how currency complaints turn into battles and eventually wars. You know things are getting serious if we start to see tariffs and price controls being imposed.
The market is poised to see a major rally in the US dollar forcing pain and bankruptcy in many USD denominated bonds. Most emerging market companies (and many countries) have borrowed in US dollars. A rally in the US dollar against their home currency will mean they eventually have to repay more than they initially borrowed. This generally isn’t a problem in our world of constant rolling over of debt (refinancing it further into the future), but it becomes a huge problem once credit markets dry up after the first sign of weakness, which usually begins with the worst rated companies (high yield bonds) and moves its way up the ladder.
Japan is between a rock and a hard place and has decided their only way out is to take the path of massive amounts of Quantitative Easing (QE) to monetize their debt. After nearly 25 years of recession, government stimulus and outright deflation, debt is now at approximately 250% of GDP. They simply can’t afford an increase in interest rates, which is why their 10 year government bond yields less than 0.5%, so they’re printing yen to buy the government bonds (called “monetizing”)to essentially eliminate them. They’ve decided to simply inflate away their debt by destroying the value of their currency. This is a process that will take many years to get their debt-to-GDP down to a manageable level where they can afford an increase in interest rates. The paradox is that they need higher interest rates today to help the economy with subtle inflation, higher wage increases and income on savings. Unfortunately, this is a similar situation that basically all western nations face. But why would Japan decide to take this route? Because they have no other choice. They’re fighting a terrible demographic structure (too many retirees, not enough workers) and fiscal stimulus has repeatedly failed to jumpstart the economy. Printing yen to cancel their debt and boost exports seems to be the best remaining option.
By devaluing the yen, Japan will put some serious pain on their largest export competitors – countries like Germany, South Korea, China and many other smaller Asian nations. It’s not a coincidence that China “unexpectedly” lowered interest rates immediately after Japan announced that they’re doubling down on their QE. South Korea also announced a cut to rates and their Central Bank lowered growth forecasts. Germany is next! Oh wait… interest rates are already at zero and they’re a member of Eurozone which doesn’t allow direct QE. Not to mention they’ve been preaching austerity on all of their neighbors to the south. A lower yen makes Japanese products cheaper than German, meaning we should soon see Germany begin to deteriorate like the rest of Europe. At that point, it will be interesting to see who wins this debate over government debt, budgets and austerity (Germany/Brussels or the southern nations of Europe). I think we’ll start to see some serious changes to “union” that is Europe as well as a much lower Euro currency.
Japanese yen vs the US dollar – 5 years
What we’re about to see across the world is everyone following suit after Japan to devalue their currency in an attempt to maintain competitiveness (or at least greatly slow the depreciation of the yen). With a large divergence between policies of the US Federal Reserve and other Central Banks around the world, we’re going to see the US dollar continue to appreciate against every other currency.
Central Bankers continue to take us down this path of more and more easing, cash injections, low interest rates and the like after each downturn in the economy, thinking they’re solving the problem each time. However, it seems as though we’ve seen each crisis bring greater volatility with booms and busts that unfold with greater magnitude over the last 30+ years. What’s the solution? Central Banks always respond with even greater amounts of financial easing and tinkering. It reminds me of a story from my favorite book Ishmael, by Daniel Quinn. The main character tells his young student that society is like an early, man-powered flying machine with pedals that flap the wings. After flying it off a cliff, the builder of the machine thinks he’s flying but starts to notice that he’s losing altitude so he starts pedaling harder and harder and the machine starts to pick up even more speed. He believes the harder he pedals the faster he’s flying, but in actuality he’s just falling quicker to the ground as gravity pulls him down. The man flying the machine thinks the solution is simply harder pedaling, not realizing that his machine is flawed and on an inevitable crash course.
Do I think Central Bankers have us on an inevitable crash course? Only time will tell. The truth is that we’re in uncharted territories and they’re steering the ship based on theory. History and the path we’re on suggest that things are going to get wild over the next few years! Not exactly what you want to hear if you’re retired or close to it… but volatility, if managed properly and large losses avoided, brings great opportunities. Investors should maintain a long-term view with an emphasis on avoiding losses at this point. If you know how to navigate the storm ahead, there will be some fantastic investment opportunities.
Happy Holidays
I hope everyone had a very happy Thanksgiving. Lauren and I travelled to Colorado last week to visit her sister, brother-in-law and our niece. It was my first time in Colorado and boy is it beautiful!
Thanks for following and Happy Holidays!
-Nick
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