My working theory is that the coming US recession is going to cause a run on the dollar and US real assets, which should benefit the rest of the world. Not Europe, which is in a recession of its own making. Not the UK, which is permanently in a political and financial mess ever since the elites decided not to give the plebs the Brexit they voted for. Not Canada, since it is too dependent on the US in terms of trade relations. Not Australia, at least not until the Chinese demand picture becomes clearer. That leaves Japan, New Zealand, South Korea, Taiwan, LatAm and rest of Asia Pacific.
I like Japan for being bold enough to continue yield curve control and not follow the Fed's footsteps. I like the yen strength. Even though Kuroda's term expires next April, I doubt his successor will change the BoJ's approach if it proves to have been the right move - and it will. While other countries central banks are busy following the Fed in hurling their economies off a cliff, the Bank of Japan is telling Mr. and Mrs. Watanabe that they should bring their capital home because it's going to be the safest place to be. Tokyo real estate over New York real estate. Nikkei 225 rather than the Nasdaq 100.
Ever since the 1990 stock market crash, Japanese capital has been moving to the US. Since US tech took off following the collapse of the commodity bubble in 2011, the rest of the world has been parking its capital in the US because the US uniquely offered both safety of capital and strong growth. Safety of capital because the Eurozone crisis made the dollar appear to be the cleanest shirt in the dirty laundry. Strong growth because low interest rates financed innovation of a magnitude not seen since the birth of the automobile, radio and other disruptive technology in the Roaring '20s. Cheap capital made the US not just a leader in tech. It enabled the country to become the world's No. 1 oil producer, overtaking Saudi Arabia for the spot. The deflation created by QE, QE2, QE3, Operation Twist, whatever you call it, made the US the place to be. Immigration, real estate, financial services, crypto - everything benefited from the decade of low interest rates. It turned out that capex booms created economies of scale that made everything cheaper, much to the chagrin of the gold bugs and hyperinflation crowd.
That golden decade is now well and truly in the rear-view mirror. The CPI will come down in 2023 due to the wealth destruction caused by the Fed's rate hikes, but it's going to stay above the 2% target over the long-term as capital flees the US. If landlords need to finance housing at 8% interest, pay higher property taxes, and suffer capital losses, you can bet they will raise rents enough to compensate. Rig counts in the Permian will keep going down as funding for exploration will dry up. Goods will disappear off the shelves when business owners figure out that they're better off sticking their capital in T-bills for a low risk 5% return than running a business with all the uncertainty.
Everything we've taken for granted due to a decade of prosperity will go for a toss as the Fed stubbornly sticks to a prohibitively high rate of interest in a recession. The natural rate of interest is determined by investors' time preference - it is a measure of consumption given up in the present for more future consumption.
A deflationary bust means prices go down. Even at a 0% interest rate, deferring present consumption will mean higher future consumption. Fed Funds at 5% while businesses can't even afford to borrow at 0% because prices (revenues) are falling means people voluntarily shutting up shop in order to enjoy the free money given out by the Fed. The Fed's balance sheet is full of long duration assets which pay out less than the Fed funds rate. The Fed will be technically insolvent soon enough if they continue down this path, adding to further stress on the dollar.
The US government is set to pay out ~$700 billion a year in interest on its current debt outstanding. That number is going much higher if the Fed continues to bleat about inflation instead of pivoting back to QE.
A situation like this does not bode well for the dollar's role as a reserve currency. Goodbye, safehaven demand. Hello, run on the dollar. Remember Carter bonds? When the US had to finance its deficit by borrowing in Deutschemarks and Swiss francs because foreigners didn't want to own dollar debt? That can happen again.
What I've just painted is the end outcome of the current Fed policy. Obviously, it won't be allowed to get that bad. Either Trump comes back in power in 2024 and kicks Powell out, or Congress steps in and revokes the Fed's charter before they go too far, but at whichever point this destruction is arrested, the damage would have been done. I believe the 50 bps hike this month crossed the Rubicon.
Monetary policy works with a lag. I don't see things getting better for the US. It's going to get infinitely worse absent an immediate U-turn on rates and more QE.
Which brings me to Japan. Sure, they've widened the band on their yield curve control but are not in the least inclined to raise rates or adopt policies with an explicit goal of causing unemployment and destroying asset prices. They've dealt with deflation for 30+ years and know how to handle it. They are leaders in industrials and advanced technology. They're going to fill in the vacuum created by the collapse in US innovation.
Buy EWJ. Best case, we get a decade of Japanese outperformance. Worst case, set a stop loss at $50.8 for a risk of 7.8%.
EWJ sector weightings tilted towards industrials and tech.
Good Trading!
Kashyap