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Conclusion: China and Japan are the latest two economies to demonstrate how our #CurrencyWar theme continues to perpetuate global economic and financial market volatility. Specifically, our work shows the Chinese yuan depreciation narrative is likely to continue weighing on global financial stability, which, in turn, should continue weigh on Japanese equities amid misguided guidance out of the BoJ.

Over the past ~48 hours, Chinese policymakers have enacted various measures designed to stabilize mainland equity markets, with the latest bout of stabilization coming via rumors of pending regulation (read: restrictions) of large shareholders sales. Additionally, Beijing was out reassuring investors that there is minimal risk of a sharp yuan devaluation despite the persistent trend of almost-daily devaluations since early November.

Since its 11/2 post-devaluation low of 6.3154 per USD, the PBoC’s USD/CNY reference rate (which the spot rate is allowed to trade within +/- 2% of) has been devalued by -3.3%. That the CNY has declined by the exact same amount in the spot market speaks volumes to the PBoC’s early success in maintaining the illusion of control over its managed devaluation.

That said, however, one key risk we are picking up on in the spread between the spot rate and the reference rate widening to the largest gap since the August devaluation throughout the WTD. While the -0.4% to -0.5% spread is hardly in the area code of the -1.5% spread we saw prior to the sharp devaluation seen in early August, another [major] cause for concern for Chinese policymakers and investors broadly is the widening spread between the offshore yuan (CNH) and its onshore counterpart (CNY). That gap has widened to -2.2% in favor of the [manipulated] CNY and is the widest spread seen on record.

The #CurrencyWar Is a War On Your PnL; Engage Appropriately - CNY

Source: Bloomberg L.P.

This confirms that persistent capital outflow pressures persist on the mainland, which should weigh incrementally on Chinese economic growth among a myriad of other structural headwinds. For more details regarding those headwinds, we encourage you to review our recent work on China:

The #CurrencyWar Is a War On Your PnL; Engage Appropriately - China Capital Flows TTM Sum

Investors would do well to disregard China’s trending economic and property market stabilization as something that is sustainable. Just because various measures of Chinese economic growth are no longer careening downhill doesn’t mean Chinese demand for the world’s raw materials and finished goods has reached an investable bottom.

The #CurrencyWar Is a War On Your PnL; Engage Appropriately - China Economic Summary

The #CurrencyWar Is a War On Your PnL; Engage Appropriately - China Real Estate Climate Index

The #CurrencyWar Is a War On Your PnL; Engage Appropriately - G20 Exports

In fact, there remains real risk of cross-asset contagion and further global economic deceleration as a result of the aforementioned headwinds to growth and inflation on the mainland that are perpetuating China’s need to devalue the yuan in the first place. All told, we reiterate our bearish bias on China.

The #CurrencyWar Is a War On Your PnL; Engage Appropriately - USDCNY vs. GFSI

The #CurrencyWar Is a War On Your PnL; Engage Appropriately - CRB vs. MSCI World ex US EPS

The #CurrencyWar Is a War On Your PnL; Engage Appropriately - CRB vs. World Gross Capital Formation

Meanwhile in Japan, that same cross-asset contagion is weighing on Japanese equities (the Nikkei 225 has dropped -6.7% MoM) via a stronger JPY (up +4% MoM vs. the USD). Recall that Japan’s net international investment position is a surplus that amounts to 75% of the country’s GDP (vs. a -40% deficit ratio in the U.S.); this implies that Japanese investors have considerable scope to repatriate capital from global asset markets during episodes of global economic turmoil.

The #CurrencyWar Is a War On Your PnL; Engage Appropriately - GFSI vs. JPYUSD

The #CurrencyWar Is a War On Your PnL; Engage Appropriately - Japan Net International Investment Position

Also a threat to consensus JPY shorts (us included) is BoJ Governor Haruhiko Kuroda’s recent guidance, which continues to be implicitly hawkish. Despite reiterating his “whatever it takes” comments and the BoJ’s willingness to ease policy further in the face of growing speculation that the BoJ may have limited scope to expand its QQE program – they are already the 2nd largest holder of JGBs at nearly 29% of the float, up from 13% prior to the April ’13 QQE launch – he continues to [foolishly] talk up Japanese inflation trends, suggesting that the board’s +2% target for core CPI can be reached without additional LSAP. Moreover, he confirmed that it may take longer to sustainably reach that target because of the ongoing deflation in crude oil prices.

The #CurrencyWar Is a War On Your PnL; Engage Appropriately - JGB Ownership 12 31 15

Source: Japan Ministry of Finance

In short, market participants are effectively calling Kuroda’s bluff on incremental QQE because his sanguine and delayed outlook for achieving the BoJ’s inflation target implies less, not more, monetary easing over the intermediate term.

It’s important to note that our analysis suggests the BoJ’s bullish bias on Japanese inflation is quite misguided in the context of Japan’s demographic headwinds.

The #CurrencyWar Is a War On Your PnL; Engage Appropriately - JAPAN 65  YEAR OLDS

The #CurrencyWar Is a War On Your PnL; Engage Appropriately - JAPAN 35 54 YEAR OLD

The #CurrencyWar Is a War On Your PnL; Engage Appropriately - Why Do 35 54 Year Olds Matter

***CLICK HERE for a full discussion of the global demographic headwinds underpinning our slower-and-lower-for-long theme with respect to the global economy and interest rates.***

As such, it is likely that we’ll need to see both Japanese stocks and market-based inflation expectations continue their respective declines before the BoJ’s hand is officially forced; 10Y breakeven rates have already declined -15bps MoM to 0.69%, which is the lowest level since the Abenomics agenda was introduced back in early 2013.

The #CurrencyWar Is a War On Your PnL; Engage Appropriately - Japan Economic Summary

All told, we think there could be another ~8% of downside in the Nikkei 225 Index – specifically because that would represent a crash from the late-June highs – before the BoJ would be forced by the markets to temporarily arrest economic gravity once again. As such, we find it prudent to [temporarily] downgrade our TREND-duration fundamental investment outlook for Japanese shares to “neutral” from a formerly-bullish bias.

For longer-term investors, we think it’s safe to reiterate our long-term TAIL bullish bias on Japanese equities and long-term TAIL bearish bias on the Japanese yen given the aggressive monetary easing we’re likely to see amid the LDP’s efforts to reach a borderline-ridiculous nominal GDP target of ¥600T by FY20 (requiring a CAGR of +4.6% from here).

That target is certainly ridiculous in the context of Japan’s trailing economic momentum as well as the demographic headwinds highlighted above. The BoJ will be forced by the Japanese economy to do exactly what economist Paul Krugman wanted them to do nearly 15 years ago: “PRINT LOTS OF MONEY”.

The #CurrencyWar Is a War On Your PnL; Engage Appropriately - LDP 600T CAGR

Best of luck out there navigating these globally-interconnected risks. Feel free to email us with any questions, comments or concerns.


Darius Dale