Will Japanese currency be the first domino to fall?

 

THE yen goes into freefall. China’s fragile economy tips over the edge. A wave of profit-crushing deflation comes washing over the United States and Europe. Investors panic.

That’s the view of perennial pessimist Albert Edwards. The London-based analyst and his team at investment bank Societe Generale SA have been ranked No. 1 for global strategy in surveys by Thomson Reuters Extel every year since 2007, even with a history of saying unpleasant things that few want to hear.

“My role is to step back from the excessive enthusiasm that builds up in the market, and to just say, ‘This is wrong. This is going to go horribly wrong,’” the 53-year-old says.

The cliche is that when the United States sneezes, Japan catches a cold. Edwards says Japan is just as apt to lead the way. When the Internet bubble burst in 2000, Japan’s tech-heavy Jasdaq index started to slide weeks before the Nasdaq. Japan also pioneered the deflation that now threatens the West. In 1997, it was a plunging yen that helped trigger Asia’s currency crisis.

With the yen’s drop this week to a six-year low of 110 versus the dollar, Japan’s currency may once again be the first domino to fall in a chain of events that could be bad for everyone, according to Edwards.

Disconnect

The US stock market rally has been going for 66 months since the financial crisis bottomed in March 2009, a streak that’s already a year longer than average. A disconnect between buoyant equity prices and corporate profit growth in the low single-digits makes the situation especially precarious.

“Almost 100% of investors think we’re at the start of a long recovery,” Edwards says. “It’s already a long recovery. Forget about starting from here.”

In an hour-long interview, during which he made the global economy sound like a game of Mousetrap, Edwards explains why investors should be watching Japan for clues about what may happen in the next big trouble-spot: China, whose economy is already headed for its slowest full-year growth since 1990.

The argument was this: if the yen falls, it will take other Asian currencies down with it. Eventually China will be forced to weaken the yuan, by adjusting its trading range and expanding its money supply, to keep its exports competitive. That will squeeze developed economies that have yet to fully recover from the financial crisis.

China syndrome

“What I’ve been saying for a couple of years – and I’ve been a voice in the wilderness – is China will ultimately have to devalue its currency,” Edwards says last week. “The yen will accelerate that.”

“Given China has so much surplus capacity and given, as well, how close the United States and Europe are to outright deflation, this could tip the West over the edge and cause a market panic.”

Japan’s currency fell 5.1% against the dollar in September, its worst month since January 2013. That sent it careening through a level of support – basically a line on the dollar-yen price chart – closely watched by traders which had put a psychological floor under the yen since 1998, Edwards says.

The exchange rate dropped 0.5% to 108.90 per US dollar as of 7:30 am in London, headed for its biggest decline in a week.

The yen’s depreciation is becoming a political issue in Japan. Prime Minster Shinzo Abe’s government pledged today to help small business hurt by it. Central bank governor Haruhiko Kuroda told parliament a weak yen won’t cause problems as long as it reflects fundamentals.

Tipping point

A divergence in US and Japanese monetary policy – with the Fed slowing stimulus and the Bank of Japan expanding the money supply by record amounts – may have started the exchange rate moving. Now that the yen is past a tipping point, Edwards says the psychology of traders is likely to take over and turn the currency into a runaway train.

“Now we’re heading to 120, which is the 30-year support,” he said. “You break through that, and you can see it moving to 140, 150 very, very quickly indeed.”

Edwards finds the yen’s price graph so compelling, he devoted an entire client note to it last week. He calls it: “Presenting the most important chart for investors.”

He followed that up with a report yesterday, offering “the second most important” chart. That showed a drop in inflation expectations as measured by Treasury yields. The picture, he said, suggests investors are losing faith in the ability of policy makers to keep the U.S. economy from sliding into deflation.

Richard Jerram, the chief economist at Bank of Singapore Ltd and a long-time Japan watcher, doesn’t buy into Edwards’ gloom. A weak yen won’t spur deflation in other parts of the world, he says. Nor would a China crash have a big impact outside of countries like Australia, which supply the larger nation with raw materials.

“Basically, it’s a domestic issue,” Jerram says.

“Obviously there’s a growth issue, but I’m not sure it really spreads beyond that.”

Japanese currency forecasters see things differently from Edwards, too. Analysts surveyed by Bloomberg predict the yen will be little changed at 110 by June 30. Only the most bearish estimate, from Ebury Partners, puts the currency at 120.

Disappointment?

Like most finance professionals, Edwards hasn’t always had impeccable timing. He’s been telling investors to reduce their holdings in equities for almost 20 years.

In his Ice Age call from the late 1990s, he predicted that deflation would eventually cover the earth, and the resulting bear market wouldn’t end until the Standard & Poor’s 500 fell to 400. The index is at about 1,950 now.

At the end of 2012, Edwards greeted clients with a holiday missive that said: “Expect the new year to bring nothing but disappointment.” The US benchmark proceeded to gain 30%.

When he’s been right, Edwards has been spectacularly right.

He made his first big call in 1996, when he was a 35-year-old strategist working for the English investment bank Kleinwort Benson.

While most investors were piling into what they thought was the East Asian economic miracle, Edwards was warning of a regional blowup. He called Malaysia’s policies “Noddynomics,” after the simple-minded title character in a series of British children’s books. Edwards says the witticism cost Kleinwort its Malaysian trading licence, but soon enough capital was pouring out of the country.

In 2006, when the S&P 500 was rising ever higher and then-Fed chairman Alan Greenspan was being feted as “the Maestro,”

Edwards called him “an economic war criminal.” Two years later financial markets were in crisis.

Edwards’ aversion to equities stems from watching the experience of Japan, where the market took more than two decades to find a bottom after the 1989 bust. According to Edwards’ view, it’s a template for the extended bear market that will unfold in the U.S. and Europe, as stocks recover only to crash again and plumb ever-new lows.

“What happened in March 2009, when the S&P 500 touched 666, that was just a brief stop,” he said. “We will go lower than that. The structural bear market ends when equities are dirt cheap.”

Where should investors now take shelter as Japan’s monetary expansion threatens to send the world crashing down around us?

Ironically, the answer Edwards is giving clients is Japan itself.

“Japan is a place where we can find quite a lot of cheap, deep-value stocks at the moment,” he said. “Just hedge out the currency.” – Bloomberg