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- This year has been a pivot: We finally saw a rate hike out of the Federal Reserve, but we’ve also had quite a few other troubling scenarios present themselves. Over the next three articles (including this one), we’re going to delve into three of the top themes facing markets going into 2016.

- In Today’s piece, we look at the top issue facing markets and that is the continued slowdown in Asia.

- This is the top theme because should it continue to develop, there is likely little that can be done by Central Banks to contain the downward pressure. This may be where Central Bank’s firepower begins to get tested, and below we look at a trade idea based around that theme in AUD/JPY.

It’s been an interesting year across markets. For traders that take cross-market exposure with equities, commodities and FX – it’s been downright fatiguing. And this might explain the dearth of activity that we saw yesterday and will likely see going into the end of the year. But ‘quiet’ and ‘markets’ doesn’t really go together very well, and with so many issues in the air going into 2016 it isn’t likely to stay quiet for very long. Over the next three articles, wepre going to look at three of the top issues facing markets going into 2016.

1) Asian Slowdown

I’ve listed this as the top concern because even if everything else goes ‘right,’ if the slowdown in Asia continues to worsen; there is likely little that can be done by Central Bankers to directly offset this pressure. As a matter of fact, it was Central Bank activity that really seemed to worsen the sell-offs in August, as China installed numerous measures in an attempt to stem the meltdown that had enveloped their equity markets. Initially, these measures only seemed to frighten investors even more than they already were; but as the Federal Reserve backed off of a September rate hike and as the European Central Bank pledged to re-examine QE in December, we saw risk assets move higher on the premise of ‘looser for longer.’

So disaster (or a market correction) has been avoided for now. But Asia is slowing down, led by China. The big question here is how far Chinese regulators will let markets fall before jumping in. As China received SDR-status from the IMF, one of the key points of acceptance was China’s pledge to move towards more market-based reforms. Just yesterday, our own Renee Mu discussed some of the measures that the PBOC is looking at in 2016 as they move to a more ‘market-driven’ economy.

But the most vulnerable economy is Asia probably isn’t China. China is still young and has a lot of room to grow; we’re likely just at the beginning of this story regardless of how things turn out this year. But Japan is looking extremely vulnerable should an Asian slowdown continue to develop, and one of the primary reasons for this is the after-effects of Abe-nomics.

Japan’s economy has some very dire stories to tell: After the run in the late 80’s that saw the Nikkei reach almost 40,000, the bubble burst in a very big way and didn’t really recover for 20+ years. This period of the 90’s and 00’s is often considered to be the ‘lost decades’ for the country of Japan, as the economy was deflating for most of the time while growth stalled. After the financial collapse sent the Nikkei reeling to a new 26-year low, it never really recovered: While stocks in the United States and Europe all appeared to get a boost on QE and hopes for higher growth, the Nikkei just hung out in that range between 8,000 and 10,000. This is an 80%+ correction from the highs in the late 80’s.

Top 3 Themes as We Approach 2016, Part 1: Asian Slowdown

Created with Marketscope/Trading Station II; prepared by James Stanley

As you can imagine, this type of economic volatility has a tendency to impact regular people; and this really hit Japan in a big way. Primarily in terms of birth rates. As Japan changed with a growing economy, birth rates plummeted as people had much more to do than just ‘make babies.’ So this started the slide, but as the economy recessed in the 90’s and 00’s, birth rates stayed low. Japan’s population aged massively, and at this point one out of 8 Japanese citizens is over 75 years of age. There are twice as many people over the age of 65 than under the age of 15. And right now there are an estimated 127.1 million people in Japan and estimates suggest that we’ll be seeing 86.7 million people in Japan by 2060. That’s a 30% contraction in population over the next 45 years. The question then becomes – how do you grow an economy when your user base is dropping by 30%? That means your GDP per capita needs to increase massively over the next 45 years just to offset this contraction in population – and that is just to keep the economy the same size that it is today.

After looking at these stats, you may be thinking ‘well this is good and all, but it doesn’t really come into play for 40 years so who cares?’ Well, that would be incorrect. This is coming into play now. The Japanese economy is controlled by retirees looking for income; income in an environment in which low rates are the name of the game. The low yielding, slow growth environment of Japan has compelled many of these retirees to invest internationally; and should another correction happen as we saw in August, these retirees will likely react in a big way and pull risk out of the market.

And the coup de gras on the Japan theme is the hit that their pension fund took in August and September after the sell-off. The Japanese Government Pension and Investment Fund is the largest pension fund of its kind; and out of necessity began purchasing stocks to transmit their QE-outlay as of Halloween 2014. As long as stocks are going up, that’s a good thing. But when markets get volatile – it’s a very, very bad thing. The GPIF reported a $64 Billion hit after the swings of the summer. That’s a -5.6% drawdown in two months – and even for a personal trader running their own individual account in a professional manner - that can be a huge number.

So, it could be rational to expect Japan to be a little more conservative with the GPIF moving forward considering the outsized hit that was taken and the necessity of this fund to an aging population; and this may hamstring the Bank of Japan towards another extension or increase of QE.

The way to play this theme is by buying the Yen, and should another move of risk aversion present itself long Yen becomes one of the most attractive ways to play that theme. On the chart below, we’re looking at some near-term levels that can be used to denote potential risk-aversion themes in USD/JPY:

Top 3 Themes as We Approach 2016, Part 1: Asian Slowdown

Created with Marketscope/Trading Station II; prepared by James Stanley

For those that want to trade the Asian slowdown theme, a better option may be found in AUD/JPY. Because if we do get that risk-aversion scenario, we’ll likely see some element of strength in both USD and JPY, so why would you want to buy Yen against something else seeing strength? A better play may be to look at another economy vulnerable to an Asian slowdown in Australia. AUD/JPY could be an accelerated trade compared to USD/JPY, and on the chart below – we can see how the pair never really recovered after the summer swoons that hit global equity markets:

Top 3 Themes as We Approach 2016, Part 1: Asian Slowdown

Created with Marketscope/Trading Station II; prepared by James Stanley

--- Written by James Stanley, Analyst for DailyFX.com

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