Tuesday, December 16th, 2014

Currency Crisis

Last week, we complained that investor reactions to the headlines were strangely muted. That was before last Friday’s sell-off. Now we seem to have entered a world where investors have suddenly accepted a “lower for longer” view on oil and started building a new jigsaw puzzle. Here are some of the issues highlighted by our models.

Emerging market currencies: This now looks like a generalised currency crisis, with obvious implications for EM equity markets. As ever there is more than one cause: the ending of QE, the collapse of oil prices, and geo-political tension. It started with the Crimea crisis in May; then the Brazilian elections knocked the real. Falling oil prices did the rest, with leading to spectacular falls in the Mexican peso and the Russian rouble.

Developed market currencies: At the moment Japan’s chief export is deflation. The massive adjustment in the yen has put huge pressure on the Korean won and the Chinese renmimbi. There is an increasing risk that China may devalue against the US dollar. Unless Hong Kong breaks the dollar-peg at the same time, this could lead to a major property crash and banking crisis in Hong Kong. Hong Kong is starting to behave oddly in our Global Equity Summary. A Chinese devaluation would also impact commodity-exporting countries like Australia and Canada.

Euro dollar FX rate: Until recently, the consensus believed that the main purpose of QE-lite in the Eurozone was to engineer a significant devaluation of the euro vs the dollar. The collapse of oil prices renders this less necessary and less attractive to the ECB. Consumer and business confidence are already starting to improve without the need for a damaging bust-up within the ECB. The euro will still fall vs the dollar, but the idea that it will go to parity or even $1.10 is less plausible.

Developed market bond yields: The fall in oil prices is major positive supply shock. We have not hit bottom yet. The greater the fall, the longer the period of low prices is likely to be. This is a major and possibly prolonged deflationary impetus. Treasury yields can go lower, as can Gilts and Bunds, though probably not JGBs.

Developed market equities: For some weeks we have been saying that Financials in the US and Europe were not reacting as well as they should be to the prospect of further ECB intervention. We now think that the explanation may be more sinister. Some of them will have loaned too much to the oil and gas sector, or have the wrong exposure to emerging markets. All of them will lose the revenues that accrued to the recycling of the petrodollar surplus. The US Technology sector also has a large exposure to emerging markets and will suffer volume and translation effects from the strength of the dollar.

Diversification stories: Whenever there is a major paradigm shift, there is a premium on situations which are not affected by the outcome. India is a beneficiary of falling oil prices but it also has an attractive self-help story. The same may be true of Japan depending on what reforms the second Abe administration will promote. As ever, well-let Commercial Property offers low volatility, good income and some capital appreciation.

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