Global outlook Solid Ground The great reset - CLSA

A structural distortion in the US Treasury market is about to unwind. The
past two decades’ flood of emerging-market (EM) central-bank capital
will end as authorities take control of domestic monetary policy. The resulting increase in EM interest and exchange rates will balance external accounts and end their accumulation of foreign reserves. Treasury yields will rise, potentially to deflationary levels. This growth shock will hit developed-world equities, while rising interest rates will depress EM equities. But this ‘great reset’ will bring opportunities worldwide as we
witness the most rapid realignment in global competitiveness since the Asian crisis, while policy flexibility will allow EM authorities to reflate their economies.

Foreign central bank support for Treasuries already waning
􀂉 India, Hong Kong, Korea and Switzerland’s external accounts are now in balance
and foreign-reserve accumulation has ended.
􀂉 China and Brazil’s reserve growth is driven mainly by short-term capital inflows.
􀂉 There is evidence of diversification, with reserves up US$421bn since September
but foreign official holdings of Treasuries down (although the data are unreliable).

Exchange rates are more flexible and interest rates rising
􀂉 EM exchange rates are rising more rapidly than they did pre-crisis.
􀂉 EM authorities are building up interest-rate premiums to US rates.
􀂉 More flexible exchange rates and interest rates mean that external accounts balance more rapidly and reserve accumulation and Treasury buying can end.

Treasury yields will rise as US economic growth slows
􀂉 In the absence of foreign central bank and Fed buying, the private sector will need to buy US$370bn of Treasuries per quarter to cover net issuance.
􀂉 A higher yield and/or lower inflation expectations will be needed to direct this
US$370bn-per-quarter flow of private capital into Treasuries.
􀂉 QE3 will be restricted as foreigners lose faith in the US dollar and Treasuries.
􀂉 Financial suppression is a more likely step to inflate away sovereign debt.
􀂉 The great reset will create major wealth destruction, but investors can profit by
waiting it out in EM currencies.
􀂉 Soon buying opportunities will appear in EM equities.