Distribution of risk to shift toward China and Japan, Morgan Stanley warns

After decisive easing actions announced by the ECB and the Federal Reserve over the last days, the distribution of risks has moved East, Morgan Stanley has warned today in a note.

“Tensions between China and Japan could lead to sudden swings in risk appetite. Indeed, Japan and China’s economies have surprised with their weak performance over the summer months and the tensions concerning uninhabited islands in the East China Sea could weaken the investment climate further. Iron ore, an indicator of the well-being of Asian economies, has dropped rapidly,” foreign exchange strategists at the bank said.

According to Morgan Stanely, China, which is in the middle of an internal power transfer, could see populism rising with some government advisers even suggesting China’s authorities sell their $200bl holdings of JGB’s to force Japan into concession.

“In our view, there is much to lose for Japan and China should the island conflict escalate from here. Japan is the biggest source of FDI in China,” the bank said.

Meanwhile, China’s economy is weak and struggling to find a better footing.

“Uncertainties concerning foreign investment in China will not help to kick start the Chinese economy. Moreover, the conflict is counterproductive in respect of creating economic confidence and planning security,” strategists warned.

On the other hand, Japan’s banking sector, which is highly exposed to JPY denominated sovereign risk, would find it difficult to cope in an environment of higher bond yields and falling bond prices.

“In this scenario, bank credit could be hit, freezing money market flows and cutting credit supply. Japan could sink even further into deflation, causing the JPY to rise sharply,” Morgan Stanley said.

The bank’s investment strategy of using AUD short positions to stabilize an otherwise risk-bullish currency portfolio seems to be paying off.

“A further escalation of the tensions at a time when Japan is preparing for its General Election in October and while China is in the middle of a power shift could keep Asian currencies and the AUD under selling pressure, we believe, with the JPY the exception to the rule,” it said.

The Japanese yen is still acting as a safe-haven anchor.

“The surprising BoJ easing move has not taken the shine off the JPY, yet. However, Japan has experienced ‘hot money’ inflows, suggesting a powerful turnaround once risk appetite comes back to life,” Morgan Stanley warned adding that in the end, both Japan and China have much to lose in the dispute, so we believe the disagreement may settle early, diplomatically.

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