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Week Commencing July 14, 2014

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This week: Outlook on currencies (and fast cars, read the report to find out how this fits in) – Week commencing 14 July 2014

For this week we will touch on the summary for each currency and its underlying economy. Our style in this report is fundamental in nature. Keep in mind we will be discussing the major currencies and where we think they are heading into the new financial year – USD, EUR, JPY, GBP and the AUD.

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USD awakening from the deep slumber

One of the most striking numbers we had to contemplate last week was the fact that the unemployment rate in Australia is almost at the exact same level as the United States. Wow! This is a combination of the Australian economy weakening from the GFC and the US economy improving. The improvement in the US economy is absolutely fascinating. The world’s largest economy has managed to devalue its currency and fight its way out of a depression like situation. The will of the American people and the American economy cannot be ignored.

This was all achieved by printing cheap money. The bears will argue that the US economy is still on the brink of collapse because the amount of debt continues to pile up. Our view for the next financial year is that the US dollar will only continue to strengthen relative to most other trading partners. Throughout the downturn, the US economy has managed to reinvent its manufacturing and become the most innovative creator of businesses that change the world globally. It is the largest equity market and source of capital for businesses and the largest bond market for the storage of wealth.

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Take businesses like Tesla for example. If you haven’t heard of Tesla Motors I suggest you spend a good half hour Googling to see the type of innovation that is now starting to drive the US economy. We’ll save you some time by adding a video of Tesla’s manufacturing facilities which you can click to watch on the left. Electric cars are the only real solution to address the type of pollution policy makers right around the world are struggling to contain. Pollution control has become a major policy issue in China.

Yes we know that the source of electricity will still generate pollution but we really think electric motor technology is a step in the right direction. Tesla is listed in the United States and I consider it to be the most important innovation in the motor space since Henry Ford launched the Model T. For us this is a microcosm of the United States economic recovery.

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The more we research and learn about Tesla, the more we like it. It's not a small business by any means, the total market capitalisation of Tesla is currently at around US$28bn as of the time of writing. This is almost half the size of General Motors Group. The most interesting part in this comparison is that Tesla recently relinquished its patents which protected its technology. The founder of Tesla, Elon Musk, wrote a very compelling reason for doing this. You can read this blog post by clicking here, we have highlighted the most important part below.

"...At Tesla, however, we felt compelled to create patents out of concern that the big car companies would copy our technology and then use their massive manufacturing, sales and marketing power to overwhelm Tesla. We couldn’t have been more wrong. The unfortunate reality is the opposite: electric car programs (or programs for any vehicle that doesn't burn hydrocarbons) at the major manufacturers are small to non-existent, constituting an average of far less than 1% of their total vehicle sales..."

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Tesla has grown from an idea - a technology start-up - to an auto maker which today has a value half of General Motors. This underpins the turnaround in the US economy and the importance of the US dollar and assets. The US cannot supress the value of its currency for too long.

Despite Yellen’s view that inflation isn’t a problem, there are growing anecdotes around that inflation outside of the official statistics is starting to ramp up. US 10 year bond yields are too low at around 2% and we think they can at least double over the next few years. Bond yields cannot sit below the rate of GDP for too long, it’s only a matter of time before investors will start to increase their operating leverage to the overall economy.

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We think Tesla can become bigger than General Motors in the next decade and in the same spirit which Apple had more than a decade ago (now the largest company in the world) the gains to shareholders are potentially significant if all goes according to plan. The US economy is back, the US dollar will soon stage a comeback and bond yields are likely to continue drifting higher as Yellen and the Fed start to face the reality of life. Many investment banks and wealth managers are already starting to bring forward their expectations for the first Fed rate hike to late 2015, we wouldn’t be surprised if this comes even sooner.

Bottom line: We’re bullish on the US dollar and see it going higher.

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Europe still has problems

As the US emerges from the downturn and innovates with the likes of Tesla, Apple, Google, Twitter etc., the Europeans find themselves dealing with deeper structural issues. Italy is still struggling to drive its unemployment rate below 12% - that’s more than double the rate of unemployment in the United States. Germany is the shining light of Europe, the world’s fourth largest economy is still growing at modest levels but the structure of the ECB means that Germany effectively has to bankroll its neighbours and this has been the cause of the sovereign debt issues in Europe over the past five years.

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The Germans have realised over the past two years that low interest rates and loose policy is the only real option, Draghi has implemented this and continues to talk up the prospect of more action. There is no turning back. With Germany looking like winning the world cup this year (as of the time of writing, the grand final is yet to be played), this might signal a more confident and assertive German stance on the world stage.

The loose policy though has a sense of desperation and the bet might not completely pay off.

Our bearish call on the Euro should come as no real surprise. Since the beginning of April, readers of this publication have heard our reasons for why Draghi needed to act – the first was to restore credibility as a central bank must with the market after months of talking the talk and the second was pressure from the corporate lobby which has seen its earnings erode as the Euro rallied against the US dollar.

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If you weren’t taken out by a tight stop loss, the trade since our initial call to short the Euro would now be in profit by around 300 pips or so.

The method of Draghi’s easing policy, the tone and the overall impression to us suggests a large layer of desperation. We think that the Draghi move to push the Euro lower and flood the system with cash is dangerous and these dangers are what every single trader out there now needs to keep in mind.

In the short term there will be a honeymoon. We have already seen the DAX break though the 10,000 barrier following the news. German multinational companies can now basically binge on money, which is free when adjusting for inflation. The banks are pressured to lend, if they hold cash they will be penalised. Corporate CEOS and executive are the biggest winners, for the time being. Some of you who read this report might be somewhat surprised by our tone, have we become bearish? Possibly, read on below if you have an interest in what has changed our mind.

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We think this ECB move is the roll of the last dice. There won’t be any second chances following Draghi’s June action. There is a growing sense of fear among many in the market that the fragile structure of Europe and the inability of governments to reduce unemployment towards levels seen in the UK and USA might lead to an all-out flight away from the Euro as a currency and the flow on effects of rising government bond yields. If there is anything that keeps us up at night it is the prospect of European sovereign debt issues returning to the market again. This time the impact will be worse because the ECB’s debt burden and the member state’s balance sheets have been put to use several times in order to get to where we are.

Bottom line: We’re bearish on the Euro and see it going higher. It’s the only thing that keeps us up at night.

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Japan should do OK because there is no other option

The money printing in Japan has also been large by historic comparison. The debt burden is huge in Japan as a proportion of GDP, BUT the vast majority of Japanese public sector debt is funded by the private sector. This will become a problem for Japan as the population ages. We think the ageing population is the single largest threat to the funding mix, combined with the artificially low interest rate environment which has been a function of huge stimulus.

On the ageing population, Japan is purported to have the highest proportion of elderly citizens; more than 24% are aged 65 or above, as of 2012.Those aged 65 and above increased from 26.5 million in 2006 to 29.47 million in 2011, an 11.2% increase. This aging of the population was brought about by a combination of low fertility and high life expectancies. In 1993 the birth rate was estimated at 10.3 per 1,000 population, and the average number of children born to a woman over her lifetime has been fewer than two since the late 1970s.The average number was estimated at 1.5 in 1993.

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A number of factors contributed to the trend toward small families: high education, devotion to raising healthy children, late marriage, increased participation of women in the labour force, small living spaces, education about the problems of overpopulation, and the high costs of child care and education. Life expectancies at birth, 76.4 years for males and 82.2 years for women in 1993, were the highest in the world.

Japan’s demographics play an important role in its GDP growth rate and the financing of its government debt. Therefore we will continue to see how the Abe government and huge stimulus being pumped into the system will play out in terms of economic data over the next year or so. In a nutshell, we doing think anything significant will emerge from Japan and the yen is likely to trade in a very small and narrow trading band for most of the year – perhaps the least volatile currency among the pairs which we are outlining in the report.

Bottom line: Don’t expect too much from the Yen, likely to remain flat until a game-changer. The chart below shows the USDJPY since the beginning of the year, the bottom indicator highlights the Average True Range which continues to slide down.

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Image: USDJPY daily chart via Invast MT4 platform, highlighting ATR indicator

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UK economy might be the standout

We’ll write more about the UK economy over the next few months but in a nutshell we think this has the potential to surprise the most relative to other global peers over the next financial year. Similar to the US economy, the UK has managed to reinvest itself and the central bank finds itself dealing with surprisingly better than expected economic numbers. As the financial epicentre of Europe, the decision not to join the Euro bloc and maintain its own independence has come back to serve as a good decision, in hindsight.

The Bank of England has held rates at a record low of 0.5% for another month in July but we think this will be harder to achieve as momentum in the global economy and financial markets starts to ramp up. The size of the Bank's economic stimulus programme, known as quantitative easing, was also kept unchanged at £375bn – for now. Last month, Bank governor Mark Carney hinted that rates could increase later this year as the UK's economic recovery becomes more secure. When it comes, any rise in rates is expected to be small by the market but they could come sooner and larger than expected.

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The UK economy grew by 0.8% in the first three months of the year, the fifth straight quarter of growth. Unemployment is now down to 6.6% and not far off where the United States is. Over the next few months we will be watching manufacturing data and corporate news very closely with the view that there is a real, growing prospect that the market will be completely surprised by an admission that monetary policy is about to change. That shift will propel the GBP even higher.

Bottom line: Watch this space. We think the market is in for a shock at how quickly economic data can improve and the response from the Bank of England is likely to be swift enough to send the pound higher.

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That leaves us with the good old Aussie dollar

We have made no secret of the fact that we feel the Aussie dollar is heading lower over the next year or so. The editor of this report, Peter Esho, outlined his reasons for this in a webinar held last month. The view there was that the Aussie dollar is probably going to find it difficult to break through the mid-90s against the US dollar and drift back somewhere near the mid 80 cent level.

From last week’s report (if you missed it, which you shouldn’t have!) “…I made the call that I think the currency will be heading back towards the mid 80 cent range over the next one to three years. At the time that I made the comments, some of those on the webinar questioned by reasoning, my charts and my conviction. I made the admission that in the short term the currency could rally to as high as the mid-90s range but then would be met with stiff resistance.

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This seems to have been exactly the case last week (3 July 2014) and I’m comforted by the fact that RBA governor Glenn Stevens came out and reiterated exactly what I said. Stevens told an audience in Hobart that some in the market will be surprised when the Australian dollar falls and by the extent that the currency can and will probably fall. He cautioned against the recent rally, spoke about the slowdown in the economy and stressed the drag that the mining slowdown will have on our economy. Stevens said “…lest there be any uncertainty about this, let me be clear, again, that the exchange rate remains high by historical standards…” As US employment prospects improve and interest rates eventually start rising from artificially low levels in that economy, the Australian dollar will continue to trend lower. I stand by my comments and am comforted by Steven’s reiteration. The Aussie is heading lower and this is a great thing for our economy. More on this next week…”

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Our view for a lower Aussie dollar was confirmed by last week’s official unemployment numbers which show the rate of unemployment in Australia is now at 6.0% compared to 6.1% for Australia. The most striking impact of the unemployment numbers are highlighted in the table below.

Table: Official unemployment numbers via ABS publication

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The table shows that the most vulnerable parts of the economy are worsening. South Australia now has an unemployment rate of 7.4% and this is before significant job losses in the car manufacturing industry is yet to flow through the economy in 2016. We made the point previously that the car manufacturing and other broader industry closures have been a function of a very high Australian dollar.

The Australian economy is still feeling the impact of the AUDUSD at near parity and the official unemployment statistics in the above table highlight this. Western Australia and Queensland have held up relatively well given their exposure to the slowing mining industry, while New South Wales and Victoria have not done enough to cushion the impact. Victoria’s unemployment rate actually grew to 6.5% - another state which is leveraged to manufacturing job losses.

Bottom line: We have made no secret of the fact that the Aussie dollar must come down and will come down as the economy disappoints. We stick to the view of the AUDUSD in the mid-80s at some point in the next year or two.

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Join the webinar to discuss these pointsA kindly reminder. Global markets are at all-time record highs yet some analysts are predicting a large potential fall. So what is install for the rest of 2014? Join Peter Esho, regular on CNBC, Bloomberg and host of ‘Your Money Your Call’, as he outlines his views on: The global markets for the new financial year;Where he sees the commodity, currency and stock markets heading; andWhich ASX stocks are primed to do well over the next twelve months? Peter’s webinar will cover both the fundamental and technical outlook going forward plus the key drivers to look out for and is expected to fill fast. Q&A will be open straight after the webinar. Register now by clicking the image below.

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