It is
always a very difficult task to predict what will move markets one year
forward, and some would go as far as saying it is futile and impossible. I kind
of agree with this point of view, but in financial markets, everything is about
probabilities, and understanding macro can tremendously help investors
‘predict’ what would be tomorrow’s most likely scenario.
What macro
analysis is telling me about the financial world for next year is all about
deflation, and let me explain my reasoning.
First the facts:
The data flow out of Japan, China and Europe is bad, strongly suggesting
appearance of the twin specters of recession and deflation.
Central
banks responses to that fact are again more monetary stimulus. Europe is
already accepting some negative interest rates, while his central bank chief
Mario Draghi, is giving very loud hints that Europe’s version of QE may be
coming. On the other hand, the world’s second largest economy, China, cut
interest rates last Friday even as out-of-control credit binges threaten
exploding debt dynamics… And last, but not least, Japan took the most dramatic
pass out of the 3 regions buy going the equivalent of “all-in” - for poker fans
- at the end of October, starting what might be considered a currency war.
Here is the
logic chain: Japan, Europe and China all rely heavily on exports. Those
stimulus strategies ultimately rely on weakening their respective currencies
which in turn makes the dollar stronger. A stronger dollar creates global
tightening credit conditions as it is the funding currency of the world economy
and thus cancels out global stimulus effects.
You have to
remember that the dollar still account for 80% of global trade transactions,
and accounts for the most part of global borrowing, for a simple reason: investors
prefer the liquidity and strength associated with the world reserve currency
tied to the strongest and most dominant economy on the planet.
As an
example, Turkey has $386 billion worth of debt payable is US dollars. Chinese
companies have raised more than $180 billion worth of dollar-denominated debt,
according to Morgan Stanley. These are two examples. Countless other EM has
huge dollar exposure. The “US dollar carry trade” has been estimated, in total,
at 3 to 5 TRILLION dollars. This means that, when the value of the dollar
rises, these USD borrowers (companies and government alike) get squeezed. And
what happens when export-focused Japan, China, Europe all attempt to weaken
their currencies, directly or indirectly, even as the Federal Reserve stays
“neutral”? They fuel strong dollar conditions, which in turn increase the risk
of economic contraction, capital withdrawal, and credit defaults. The game is
self-defeating.
What seems
to be clear for me is that we are entering a negative feedback loop that may
impact greatly financial markets. If my theory is correct, some exceptional
money-making opportunities are at hands.
Commodities
are the most at risk in this scenario and the fact that they already started a
break out is confirmation of my theory. A stronger dollar means weaker
commodity prices: Intermarket Analysis 101. I was alerted earlier this year by
the Crude Oil break down that surprised many in financial medias, who failed to
apply the saying “what can’t go up on good news must go down”. The price of Oil
refusing to move up during the escalation of 2015 geopolitical tensions
(Ukraine, Middle East) was a wonderful hint of what would be coming later in
the year… Deflationary forces generated by US Dollar strength was much stronger forces and not surprisingly
commodity prices broke down in tandem after the summer.
But I think
this is just a start! I believe that the commodity bullish secular cycle has
ended. Therefor I opened a short AUD/USD at the start of November from 0.8720
after the completion of the small October consolidation pattern hoping for much
lower prices around the 0.8 figure. I choose this currency pair because AUD is
a commodity currency, as its economy relies heavily on exporting its resources
to other countries, mainly China… which I am not optimistic about as well. I
can also profit from the dollar appreciation in the meantime, so with the price
action looking good to me it feels like a good play.
I will try
to do some follow up on that position here in the blog and gives as much update as possible.
