This week, the Bank of Israel had the honour of delivering the 512th official interest-rate cut seen around the globe since the start of the financial crisis in 2008, according to Bloomberg.
In all, countries accounting for around a quarter of the world’s GDP – including Australia, South Korea, and Kenya – have cut rates this month. While the global economic backdrop is hardly spectacular, there are few signs of imminent collapse either. So why the sudden global embrace of ‘easy’ monetary policy?
Blame the Bank of Japan. At the weekend, at a meeting of the G7 developed nations, the gathered luminaries effectively gave Japan the greenlight to continue its campaign to weaken the yen.
The value of the Japanese currency has plunged from as low as 77 to the US dollar in less than a year, to 102 to the US dollar this week. And the devaluation may have only just begun – Capital Economics reckons it could fall as far as 120 by the end of 2014.
It’s easy to have sympathy with the Japanese. Japan is an export-dependent economy. Yet since the financial crisis, their manufacturers have had to bear the brunt of being among the few major nations in the world with positive ‘real’ (post-inflation) interest rates. With Japan immersed in deflation, even an interest rate of 0.5% delivers a real return.
So with America and Britain printing money, and even – albeit sporadically – Europe loosening monetary policy, Japan looked attractive. By embarking on a massive money-printing spree now, it’s just doing what the other major central banks have already been doing for a while.
The trouble is, as William Pesek points out on Bloomberg, the yen’s sudden weakness is sure to increase global tensions. Because it’s not the only country in the world that relies heavily on exports.
Exports account for around 40% of Israeli GDP, one key reason behind this week’s rate cut. And, notes Pesek, “trade partners, including Australia, New Zealand, the Philippines, South Korea, Switzerland and Thailand, are scrambling to cap their currencies. What happens when China, already at loggerheads with Japan over a disputed set of islands, joins them?”
In short, the currency wars are really heating up. Central banks around the world have decided that worries about inflation can wait until another day. The gloves are coming off. But what does this mean for your money?
The signal from the gold market
In late January this year, we looked at the likely winners and losers of a global currency war. We noted that you should be betting on a weaker yen (by buying Japanese stocks), and that eurozone stocks were also worth buying, with the euro likely to fall in the longer run.
We reckoned you should diversify out of sterling (then at $1.58, compared to $1.53 now) by investing some of your money in non-sterling-denominated assets and in US dollar-earning blue-chips.
We warned that the commodity currencies – and the Aussie dollar in particular – looked vulnerable (the Aussie has fallen from around $1.03 to below parity with the US dollar). And the big winner in all this was going to be the US dollar.
So far, so good. We haven’t changed those views much. The US dollar remains the currency with the best prospects. Even though talk of an exit from quantitative easing (QE) seems premature, the country and its banking system are further along the road to recovery than most other developed nations, and with the added boon of shale gas and a rallying housing market, the US is also in a healthier fundamental economic position than its peers. We look at ways to continue playing these themes below.
However, we think this latest phase of the currency wars signals a more significant turning point. And as so often happens, one of the clearest signals came from the gold market.
It’s worth thinking for a moment about what really drives the gold price higher. Many people argue that it’s inflation. But that’s not strictly the case. As Paul Marson of Lombard Odier noted in research from 2011, gold’s main use is as a hedge against extreme scenarios.
Looking back as far as 1929, in cases of both deflation (inflation below -1%) and very high inflation (12%-plus) – both of which tend to indicate a serious problem with the financial system – gold tends to perform well. Put more simply, gold does well when the level of stress in the system is so high that people simply can’t bring themselves to trust other assets.
When you look at what killed gold’s last long-term bull market in 1980, this makes sense. It wasn’t so much the end of inflation that did for gold. It was Paul Volcker, then head of the US Federal Reserve, convincing people that he would do whatever it took to squeeze inflation out of the system, regardless of how high interest rates had to go.
It was painful for a time, but eventually investors calmed down, realised that other investments were offering highly attractive yields compared to gold, and invested accordingly. This also puts a different light on gold’s recent slide into bear-market territory.
Somewhat ironically, this time around the slide has come just as central banks are promising to do “whatever it takes” (in the words of European Central Bank boss Mario Draghi) to tackle the threat of deflation, and to print money if needs be to avoid any future banking collapse.
As investors become more and more convinced that central banks have the ability and the determination to underwrite the financial system, they will be less keen to hold gold and will instead be more willing to put their faith in stocks, for example.
This might sound contradictory. But not if you consider it for a moment. Gold hit its high of more than $1,900 an ounce in September 2011, at the peak of the eurozone crisis. Within a year, Draghi had made his speech about saving the euro, and gold never regained that peak. And its most recent plunge follows hot on the heels of Japan’s decision to embark on the biggest money-printing experiment the world has ever seen, inspiring another bout of euphoria in global markets.
In short, the war between inflation and deflation, which has gripped the markets ever since the great financial crash in 2008, looks like it may well be over, bar the shouting. As far as central bankers go, it’s “inflation or bust!”
The next phase of the crisis
If most of the world’s central banks are now committed to the ‘great reflation’, and investors are convinced of this, then is everything OK now? Not so fast.
As Hugh Hendry of Eclectica Asset Management points out: “Japan’s monetary pivot towards QE will not create economic growth out of nothing. Instead it seeks to redistribute global GDP in a manner that favours Japan versus the rest of the world… a resurgent and competitive Japanese export industry does not bode well for economies in Europe and the rest of Asia.”
In other words, it’s pure ‘beggar-thy-neighbour’ stuff – Japan in many cases will simply be taking business from its rival export nations. And as Charles Dumas of Lombard Street Research points out, the biggest loser from all this could be China.
The problem with China is that while Japan’s currency has devalued, and encouraged copycat action around Asia, notably from South Korea, the Chinese yuan has strengthened. So labour costs are increasingly uncompetitive, harming the Chinese economy.
Meanwhile, the banking system is riddled with bad debts and the property market is hugely overvalued. Given this “bubble-like pricing, the danger is that prices could start to cascade downward at any time”, says Dumas.
One solution for China, which would help weaken the currency without being politically problematic, would be to remove capital controls entirely and allow Chinese citizens to invest their money overseas. The trouble is, that would lead to a flood of capital leaving China, which would also increase the chances of “a major bubble-burst”.
What would be the end result of a China bust? The most vulnerable assets, says Dumas, “are those that benefited most from the misconceived Chinese recovery policy of 2009-2010: real estate, in China, Hong Kong, Singapore, central London etc, and hard commodities, which were grossly inflated by China’s orgy of metal bashing in 2009-2011”.
In the longer run, if China does loosen capital controls in an effort to devalue its currency, then money will flow from China to boost stocks and US property, reckons Dumas.
The end of the bond bull market
The other big worry is what happens to bond markets when investors become convinced that inflation is on its way back? Many pundits are already fretting over signs of ‘normalisation’ in the Japanese bond market. As Julian Jessop of Capital Economics points out, the yield on ten-year Japanese government bonds (JGBs) fell as low as 0.45% on 4 April. But since the Japanese money-printing bonanza was promised, the yield has risen as far as 0.85%.
That doesn’t sound like a lot, but it’s a huge move by government-bond standards. The market has gone ‘limit down’ – in other words, JGBs have fallen by the maximum daily amount allowed – on several occasions since the Bank of Japan announced its money-printing plans.
This isn’t necessarily a disaster for Japan. In fact, as Jessop notes, it might be a sign of the policy’s success, if it simply shows “there is a growing recognition that if the attempts to create inflation actually work, long-term interest rates should end up higher than they would otherwise have been”.
And as Michael Taylor of Lombard Street Research adds, if interest rates on bonds are rising because inflation is rising, then nominal GDP will head higher too. This will help to reduce Japan’s hefty budget deficit and national debt. Higher interest rates would also be good for Japanese consumers because, unusually for a developed economy, they are “net recipients of interest income” because they have so much cash in the bank.
Japan is also starting from a very low base. With deflation entrenched in the economy, Japanese government bonds still offer a positive ‘real’ (after inflation) return, meaning a rapid flight away from JGBs still seems unlikely.
You can’t say the same for British government bonds (gilts) or for many US Treasuries. Bill Gross – one of the most high-profile bond-fund managers in the world – believes that the 30-year bull market in US Treasuries ended (very specifically) on 29 April this year.
He doesn’t expect a full-blown bear market any time soon, but the very fact that he’s willing to make such a specific call suggests bond investors should be wary.
And even David Rosenberg of Gluskin Sheff, a noted bond bull and deflationist, is getting worried about the danger of inflation taking off in America. “Prolonged periods of negative or zero real rates never end well. The Fed historically overstays on the easing cycle, and it is no different this time around.”
Like Gross, Rosenberg isn’t screaming for a bond bear market: “as a long-term bond and income bull, I am not about to throw in the towel”. But he is suggesting caution. “I am no longer… in the same comfort zone I once was.”
We’ve been arguing that you should avoid bonds for quite some time now, and this doesn’t change our views. We’d agree that the Fed is likely to keep its foot on the accelerator for longer than anyone expects, regardless of various murmurs about the latest QE programme being pulled. And to bring it back to gold, this is also why you should keep hold of the yellow metal as insurance (about 5%-10% of your portfolio).
The inflationary ‘sweet spot’ of just below 4% that tends to be good news for stocks may not last for long if the world’s central banks are intent on currency devaluation. And a surprise, nasty reawakening of inflation would be a lot better for gold than the benign disinflationary environment we saw in the wake of the Volcker era.
The investments to buy into now
We’ve been fans of Japan for a long time. The yen has depreciated sharply in recent months while stocks have soared, but we think there’s still room for more.
The Baillie Gifford Japan fund we tipped last time is now up by more than 50%, beating both the iShares MCSI Japan GBP hedged fund (up around 30%) and the Neptune Japan Opportunities fund (up around 25%). But if you bought them, we’d hold on for further gains.
My colleague Paul Amery looks at some other options for investing in Japan here. We’d also stick with the cheap eurozone markets. We highlighted Italy last time, and although the FTSE MIB tracker (LSE: IMIB) has slipped by around 2% since then, the Italian political situation now looks healthier. And with even the German economy looking weak now, resistance to money-printing by the European Central Bank must be weakening.
If you’re interested in playing the currency markets directly, spread betting is probably the easiest way to do it. Do be aware that this is extremely risky and only for investors who are confident they understand how it works – to learn more, sign up for our free email, MoneyWeek Trader
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Overall, we’d be short the Aussie dollar and the Japanese yen against the dollar. Another interesting, more exotic, play is to short the Aussie dollar against the Canadian dollar (the Loonie). Both the Aussie and the Loonie are commodity currencies (their economies depend on exporting various resources), and both nations suffer from over-inflated housing markets.
But if you believe that the US is on the road to recovery, while China is on the road to disaster, then Canada’s currency should outperform the Aussie: while Australia is geared to the Chinese economy, Canada’s is geared to America.
While it may take some time for inflation to rear its ugly head in a way that rattles markets, we’d still generally avoid both government and corporate bonds, or at least ones offering a fixed income. Yields on even the most exotic bonds have been driven to record lows (for example, Spanish energy group Repsol has just managed to issue a seven-year bond at the lowest rate achieved since Spain joined the euro). The asset class looks very vulnerable to any nasty surprises.
As far as gold goes, as we’ve noted before, we see it as insurance against extreme financial events. Central bankers have a long history of taking too long to tighten up monetary policy, and we don’t think this time will be any different. You can buy physical gold through the like of Lingold.com or BullionVault.com, or buy via a physically backed exchange-traded fund.
We’d generally avoid the commodities sector due to falling Chinese demand, but if you are interested in beaten-down miners, gold miners may be worth a look. They are cheap relative to the gold price, and if costs come down (as they should, if the mining sector in general is slowing) then you’d expect profits to improve.
The Blackrock Gold & General Mining fund has a great track record, or if you’d prefer an exchange-traded fund, you could buy one tracking the US HUI index, which is an index of unhedged gold producers.