A normal country is not a closed economy; foreign investment, international trade, and capital flows are major influences on that country.
1. What determines a country's asset prices?
Determined by profit and discount rate, where profit divided by discount rate is a macro concept. For companies, it refers to net profit or EPS, and the discount rate is the actual cost of funds, which can be represented by the real interest rate or simplistically considered as the nominal interest rate, similar to the PE concept.
2. In the absence of foreign investment interference.
A reduction in profits with the central bank still tightening policy is rather rare, but if we consider that the capital markets trade on expectations, then the US stock market at the end of 2018 was close to this situation—rising unemployment rate with the Federal Reserve still raising interest rates. If there are no special circumstances constraining the central bank's actions, it should enter a rate-cutting cycle to support economic growth.
The fluctuations in asset prices depend more on profit and discount rates, which has a greater impact.
3. In the presence of foreign investment.
Assuming you are a dollar fund manager, how would you consider cross-market investment strategies?
Not only should the future expectations of asset prices in that market be considered, but also how the country's exchange rate will change. As a dollar fund, your final net assets are settled in dollars. For example, if your investment object in a foreign country rises by 20%, great, but then you notice that the exchange rate depreciated by 50%, resulting in a decline in your net worth valued in dollars.
4. When should you enter the market?
You definitely invest when foreign asset profits are high. At this time, the central bank is often in a rate hike cycle, foreign asset returns are high, and the central bank is tightening monetary policy. If US dollar interest rates are at a low level, financing costs are low, and the foreign exchange rate appreciates against the dollar, you can finance at a lower cost, invest in foreign countries, enjoy high asset returns, and also benefit from additional returns due to exchange rate appreciation. This high return attracts more investment managers to make similar allocations, investing more funds to buy foreign assets, driving up asset prices, and the exchange rate will also rise, forming a self-reinforcing cycle. This is also why we have seen global stock market valuations expand whenever the dollar is at low interest rates over the past 20 years.
5. Under what circumstances would the cycle be broken?
Often because the returns on foreign assets cannot be sustained, or the domestic financing costs rise; the former indicates asset deterioration, while the latter indicates changes in liabilities. At this point, the game link will turn left, leading to a decline in foreign asset prices and depreciation of the exchange rate...
The core judgment of overseas investors is whether foreign assets priced in dollars will rise, which means the asset return plus the changes in exchange rates must be worth investing.
6. The trilemma of interest rates, exchange rates, and asset prices
Under the influence of various macroeconomic factors, economic slowdown objectively exists. The interest rate curve should decline, indicating that the central bank initiates a loosening monetary policy cycle. From the perspective of external investors, our assets priced in dollars should be revised down. In a natural market environment, assets priced in local currency often show a decline in asset prices, and the local currency depreciates. The depreciation of assets priced in dollars is contributed partly by the downward adjustment of asset prices and partly reflected in the depreciation of the exchange rate.
In 2023, the situation is chaotic; those paying attention will notice that the fluctuations of the CNY exchange rate are almost entirely consistent with the 10-year US Treasury yields. In contrast, Chinese bond yields are declining unilaterally, clearly violating the normal market mechanism. At that time, for understandable reasons, they did not want the exchange rate to depreciate too quickly, forming an artificial ceiling at 7.35. When US economic expectations are strong, and the dollar is strong, we control the extent of CNY depreciation, which comes at a cost.
To maintain a relatively stable exchange rate, the freedom of monetary policy is inevitably constrained. Logically speaking, when there is pressure on economic growth, the interest rate curve should be lowered, but the exchange rate target prevents the central bank from quickly lowering the interest rate curve, which accumulates economic pressure and further deteriorates the expectations of asset returns.
Among interest rates, exchange rates, and asset prices, at most two can be chosen.
; If choosing between asset prices and exchange rates, interest rates must be significantly lowered to improve economic expectations and stabilize asset prices and exchange rate expectations.
; If choosing between interest rates and exchange rates, then asset prices will inevitably bear immense pressure. From an external perspective, your assets are priced in dollars, and if the exchange rate remains unchanged, it is the asset prices that must bear all the downward adjustments in dollar terms. This is the situation in the second half of 2023, where small and medium-sized stocks are more likely to be affected.
; If choosing between interest rates and asset prices, the exchange rate would need to depreciate significantly to share the pressure on asset prices, which might be this year's choice.
Will a significant drop in exchange rates cause a large drop in asset prices? If it happens, it will also be accompanied by a decline in bond prices, which is a triple kill of stocks, bonds, and currencies. This often occurs during economic downturns, especially when debt credit problems explode, such as at the end of August 2023 when local debt issues surfaced, and the central government conducted debt swaps. This behavior harms credit, leading to bond sell-offs, exchange rate depreciation, and a decline in asset prices.
