(Yicai) Jan. 19 -- Arthur Budaghyan, the chief strategist for Emerging Markets and China Investment Strategy of independent investment research firm BCA Research, warned of an impending significant depreciation of the US dollar, driven by an unsustainable balance of payments situation that could reshape global investment landscapes.

The United States is running a substantial current account deficit of around USD1.4 trillion over the past four quarters, which has been primarily funded by unprecedented portfolio inflows from foreign investors, Budaghyan said recently in an exclusive interview with Yicai.

A significant decline in portfolio flows would lead to "a massive reduction in capital flow," he noted, adding that the greenback would likely depreciate significantly this year and global investors should "get out of the dollar."

Excerpts from the interview are below: 

Yicai: You argue that the primary driver for the US dollar is shifting to the BoP equilibrium from interest rate differentials. Is this because there is limited room for the Federal Reserve to cut rates, or have we reached a tipping point where existing capital inflows can no longer sustain the massive deficit?

Arthur Budaghyan: I believe it is the second factor, the massive current account deficit. The US is currently running a current account deficit of approximately USD1.4 trillion. This is being entirely funded by portfolio inflows—specifically, foreigners purchasing US stocks and bonds. In the past year alone, foreign net purchases of US equities reached a record USD700 billion, which is by far the largest in history.

However, this global rush into US stocks is nearing its end, which implies a significant slowdown in future inflows. For instance, instead of USD700 billion, we might see that figure drop to USD300 billion, while still a net inflow, the magnitude is substantially reduced. The same applies to the bond market. Over the past 12 months, bond inflows have been around USD700 billion. Going forward, they may decline to USD500 billion.

If total portfolio flows decline from the USD1.4 trillion seen in the last 12 months to USD800 billion or USD1 trillion, it would represent a massive reduction in capital flow. When US consumers or businesses seek to buy imported goods without a sufficient capital offset to fund that deficit, the dollar must fall. I expect the dollar to depreciate significantly this year. My core theme for global investors is: get out of the dollar.

Yicai: You characterized the US dollar as the "muscle" that forces the BoP into balance, but this is quite counterintuitive, with the prevailing view being that imports will stay high as long as US consumers have a spending desire. Based on the BoP identity, do you argue that a contraction in imports is an inevitable "forced" outcome, regardless of consumer sentiment?

AB: The question I often receive from investors is, "If US consumers still have jobs and income, why would they stop buying goods? Why would the US current account deficit shrink?"

The answer lies in the fact that the BOP is an identity. The Current Account deficit must, by definition, equal the Capital, or Financial, Account surplus. If the Financial Account surplus, which currently stands at approximately USD1.4 trillion, declines, the Current Account deficit has no choice but to shrink as well.

This is what I call the "alligator bite." If the upper jaw (capital inflows) moves down, the dollar acts as the muscle that pushes the lower jaw (the trade deficit) upward toward balance, resulting in a snap. My message is do not get caught between those two jaws, because the alligator will bite you. That is why you should get out of the dollar and exit US assets.

If foreign funding is unavailable, consumers in any economy simply cannot purchase foreign goods; that is an accounting identity. While US consumers can continue to buy domestically produced goods or services, such as entertainment and travel, they cannot sustain the purchase of imported goods without the necessary funding to offset the trade gap.

What happens if they attempt to buy without that funding? The dollar will plummet. As a result, exporters from China, Japan, and Europe will face a significantly weaker dollar, forcing them to hike prices just to make their sales economically viable. Between currency depreciation and potential tariffs, imported goods will become so expensive that US consumers will be forced to slash their spending on them. The dollar, therefore, is the equilibrating mechanism for the BoP.

If my primary assumption is correct, that foreign portfolio inflows into the US will decline, the rest will play out mechanically, like a Swiss watch. The dollar will fall to ensure that US consumers are forced to reduce their consumption of foreign goods.

Yicai: You mentioned that the global rush into the US stock market is ending. While price-to-earnings ratios are extreme, many argue that we should use price/earnings-to-growth ratios to justify current prices.

Do you think relying on the PEG ratio is a "narrative trap" typical of a market bubble? And what brings you to the conclusion that we are seeing a global equity leadership change?

AB: It's risky to call major regimes or leadership shifts in the market, especially after 15 years. But that actually makes me more comfortable. I've seen many cycles, and nothing lasts forever.

The key reason to be bearish on the US stock market is that the forward-looking growth will not match the backward-looking growth. While the PEG ratio might look reasonable today, it is a function of past performance that assumes future growth will be just as robust. However, I bet there has been a fundamental regime shift in the US tech sector.

For the past 10 to 15 years, US tech companies have practiced extreme capital discipline. They generated massive revenue with limited CapEx, resulting in very high return on capital. Now, US hyperscalers are investing "big time". When you invest too much, too fast, it typically leads to the misallocation of capital.

Your capital base grows, but profits often disappoint relative to that growth. As a result, the ROC for US stocks will be much lower in two to four years than it is today.

Stock market valuations are very high because the market is looking at the ROC that these companies have achieved in the past five to 10 years. But when you invest a lot, your ROC is going to be much lower.

On a more granular level, the data centers being built today at massive expense will likely become obsolete in three to five years. Technology moves so fast that these companies will soon learn to build more efficient and cheaper infrastructure. History shows that early methods are quickly surpassed by innovation.

Because today's data centers are so expensive to build, they will struggle to compete with the lower-cost facilities of the future. They will be forced to cut prices to stay competitive, despite their high cost base. This is great for humanity and artificial intelligence users, but it is a disaster for the companies currently sinking trillions of dollars into this infrastructure.

Yicai: You warned that the downturn in the global manufacturing cycle will sap the momentum of emerging markets' non-tech stocks, advising "avoiding risk assets". However, you still maintain a neutral weight for such markets. If the cyclical headwinds are so strong, why not move to a full underweight?

AB: A neutral allocation to emerging markets is defined relative to a global equity benchmark. For an illustrative portfolio, I recommend a lower total exposure to global equities than the benchmark. For instance, an allocation of 100 relative to a benchmark of 120. Within this reduced total equity exposure, however, I advocate for a neutral weighting toward emerging markets.

This stance is driven by my view that the US market will likely be the worst performer. Consequently, I am "maximum underweight" on the US, while remaining neutral on emerging markets, overweight on Japan, and slightly overweight on Europe.

The heavy concentration of US technology stocks represents a significant systemic risk. A correction in this sector, coupled with a depreciating dollar, would inevitably lead to US underperformance. Regarding global trade, the recent resilience has been supported almost exclusively by robust US imports. Should these imports contract, as my BOP analysis anticipates, global trade would lose its "only branch". Thus, I maintain a bearish outlook on global trade volumes.

Historically, emerging market assets underperform during trade contractions due to their high cyclicality. Emerging Asia remains heavily dependent on manufacturing and exports, while global industrial activity dictates the prices of industrial commodities, the primary driver for Latin American economies. Despite these cyclical headwinds, I remain "neutral" on emerging markets because I expect these markets to outperform US equities in dollar terms.

My overweight position in Japan is fundamentally a currency play. The Japanese Yen is currently significantly undervalued. While short-term volatility could lead to further depreciation, I expect a substantial appreciation on a 12-month horizon.

Regarding Europe, while I remain pessimistic about regional growth, I am constructive on its equity markets relative to the US. Historically, European investors have recycled large current account surpluses into US assets.

As the US market's relative appeal fades, this capital flight should abate, putting upward pressure on the Euro. This currency tailwind should allow European markets to marginally outperform the global benchmark.

Editor: Martin Kadiev