"Is that clear?" - "Crystal, Sir"

• US policy will determine asset price directions in 2014

• US $ will gain against EMs with weak current account balances like TRY. US$ will gain against countries with opposing monetary policies like the JPY.

• China will slow but not crash affecting China dependent currencies like AUD and some commodities.

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A lot has been made of monetary changes especially in the USA. It is time that we took a closer look at the state of the USA and its potential effects on the rest of the world, since we believe that these changes will dominate investment themes for the foreseeable future.

The first point to make is that easy money is going to be reduced and monetary policy will become tighter, since the US economy will be gathering speed in 2014. When the crisis hit in 2008/9 monetary authorities were faced with the dilemma that interest rates should in face be negative in order to off-set the massive deflationary forces of the great recession. If we put that into a central banker's concept then the Taylor Rule would in fact suggest that interest rates should be negative 4-6% in the USA at the height of the crisis.
                                 
                                         Taylor Rule augmented Rate & suggested Rate

However, nominal interest rates cannot become  negative and hence monetary authorities needed to find new methods to inject growth into the economy. The chosen method and probably the best possible option available was QE, in other words increasing the money supply within the country in order to increase liquidity within the financial system and in order to persuade banks to increase loans into the economy. Additionally, QE would keep longer term interest rates at lower levels, which again would assist in making credit cheaper and more readily available. This would have the benefit for investment decisions and would push investors to take more risk. Taking risk would in turn become a positive tailwind for the economy as investments, start-ups  equity purchases, property purchases and increased consumption would assist to fight the economy's slowdown. This expansionary economic impulse would also benefit the unemployed, as an expanding economy would need more labour.

All of the above have to a certain extent materialised: Unemployment has fallen, economic growth has increased, longer term interest rates have fallen substantially, housing has recovered, bank lending has improved especially to small and medium sized companies, and the equity markets are at an all time high. Combined wealth effects should now also assist consumption to rise over the next 12 months. Overall the US economy is improving substantially even though growth numbers for 2013 do not fully reflect this. This is due to the large amount of fiscal tightening that was imposed by the US government in their infinite wisdom, which has shaved off more than 1.5% of GDP in 2013. It is a credit to the US economy that despite these headwinds (which include a reduction of 0.1% of GDP due to the federal shut-down) growth is positive around 1.5-1.9%. Next year these headwinds should be eliminated for the most part (by the end of Q1 2014), which should enable the US to grow at substantially faster rates approaching 3%.

All of the above indicates that the US will do better over time and that current monetary policy is too lax for the underlying economic growth rates. Looking again at the Taylor Rule, we can see an implied Fed Funds Rate of around 2% without any QE. Given current Fed rates at 0.25% and QE of 5bn$ per month, current implied Fed funds rates are still lingering in deep negative territory. This stimulative environment should assist the US to recover even faster but it poses difficulties to monetary authorities, as asset price inflation has potential to build especially as the output gap becomes smaller and smaller. The Fed is aware of these dangers and has already announced that it will scale back its monetary expansions in 2014, we believe tapering will begin in March 2014 and will be finished in the first half of 2015.

The effects of eliminating QE injections will be profound for the markets both in the US and abroad: We have already seen that the mere talk of reducing QE has resulted in 1) Long term interest rates to rise substantially 2) EMs to suffer an exodus 3) the US$ to reign supreme...what can happen when the actual event occurs...

The key areas of danger for the world economies lie in policy errors, where the Fed reduces QE too quickly and stifles economic growth at home, while capital flees EMs and leaves them with substantially reduced asset prices and lower growth rates. However, we believe that policy errors will not occur as our forecast of US economic strength is substantial and Yellen is more dovish than Bernanke and has a very good grip on economic analysis. Current weak US economic data has to be interpreted in the light of consumer frustrations due to the government shut-down and associated policy uncertainty.

The whole world will not recover at the same fast pace that the USA has set out. In fact our analysis points to the USA being one of the only major DMs that will reduce monetary stimulus. When the crisis began monetary policy was synchronised and every country fought the deflationary forces of the Great Recession by cutting interest rates to negative real rates and increasing credit. This has benefited some countries more than others. Especially EMs had a huge capital inflow of around US$4tr in the last years since 2008-9. This capital will now begin to leave those countries for safer alternatives, FDI will not be the exclusive territory of EMs any longer and this will have profound effects.

The USA has been the liquidity provider to the World for decades and any reductions in the US current account balances have resulted in liquidity reduction which have caused the rest of the world to suffer substantially. During such tightening periods the US$ has been the main beneficiary and hence we are bullish the US$ as a theme for 2014. As our long term readers know, monetary tightening will also affect US treasuries negatively, as well as other real rate dependent assets like gold negatively (see "Gold under the mattress...again? October 9, 2013).

Let us have a quick look against which countries the US$ will win the most. In the EM world countries with large external deficits who have benefited the most from previous capital inflows and have not taken monetary steps to offset the coming liquidity crunch will suffer the most.

Other countries that will take a major FX move against them will be countries that actively expand monetary policy while the US is decreasing theirs. Japan is one such country which requires massive monetary expansion in order to escape the deflationary environment that has been plaguing the country for the last few decades. In short, we are short the Yen and Turkish Lira vs the US$ and intent to remain so for the foreseeable future.

One more country and its influence needs to be quickly explored here: China is one of the most important markets for commodities, as it has become the largest importer for crude oil, consumes about 40% of copper and largest soya consumer on the planet. Its ravishing growth rates over the last decades of 10%+ have caused investors to turn their heads and take note. FDI has in turn sky-rocketed to astronomical numbers, and have become China's single biggest economic growth driver. The 2008 "Great Recession" has caused a nice and uniform monetary response from developed markets and emerging markets: all in unison expanded their money supply and credit growth. China was no exception in that the government decided to increase the gates of credit and poured money into the economy, thereby causing asset prices to inflate and growth rates to be sustained for the most parts, especially property prices.

Now, however, the game is changing, as discussed above FDI is slowing into EMs and finding a new home in DMs. The Chinese authorities are aware of this and are trying to turn the Chinese economy into more of a consumer driven economy. They are doing this by increasing the value of the renminbi, while trying to limit credit expansion. Looking at China's levels of debt we see clearly that debt levels are reaching such extremes that growth rates will begin to decline in the future. (Total debt levels above 200% begin to slowly eat into longer term growth rates.)

We do not see a crash for 2014 since managed economies have an amazing ability to continue propping up their economies for a lot longer than anyone thinks. We have seen this movie in Japan a few decades ago, where the Japanese government continued to keep their 'ghost' banks solvent even when there was no economic reason to do so. The same and more applies to China, since the Chinese government in effect is the sole decision-maker for credit and its expansion. However, we do believe that China will slow down and its growth rates will diminish more next year than the markets expect. It would be easy to see their GDP growth falling by another 1% next year to around 6-7% yoy growth. This would affect China's appetite for some commodities and would also affect exporting countries that are China dependent, like Australia.

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