Last week the People’s Bank of China took the unexpected action of devaluing their currency, the Yuan (Renminbi), for 3 consecutive days.
It never ceases to amaze me how the unexpected can work people up into frenzy. The only people that see this type of thing coming is the ammo-and-canned-food crowd who, for years, constantly call for a particular event to occur, and then when it does are the first to say “I told you so.”
If you're a regular reader of news or financial sites, the headlines alone would make you think you should be worried even if you’re necessarily inclined to get caught up in the media hype. Some of the headlines from last week:
“Will China Shock Bring Fed Delay?”
“China Can’t Risk Devaluation Chaos Shock”
“China’s Scary Lurch Back to Socialism”After the VIX Super Spike, is the Worst Ahead”
“The Yuan is the Chinese Monetary Panic Button”
“Did China’s Devaluation Crush Yellen’s Rate Hike Strategy?”
With words like “shock,””chaos,””crush,”and ”panic” what are investors supposed to think? Headlines like this are meant to encourage clicks so that you’ll read the articles, they are not, generally, speaking, indicative of reality.
Stick to your process.
If your framework is solid, then it works whether markets are going up or down. Your process will tell you what markets to be involved in and which side of that market provides the best risk to reward characteristics.
I’m emphasizing that it's important not to get caught up in the headlines and rather, drill down and evaluate whats really happening.
The PBOC started the week off by allowing the Yuan to decline 2.25% against the US Dollar. This caught the world by surprise and led to a mountain of speculation about the ramifications for world markets and global economies. The Yuan weakened further on Tuesday and Wednesday, before the PBOC stepped in the last minutes of trading and propped up the currency. The Yuan went on to rally on Thursday and Friday, closing the week just above the 2014 lows and down approximately 3% on the week.
The main economic benefit of a weaker Yuan is making Chinese exports more competitive. The reason exports are such a focus for China is that they account for more than 20 percent of GDP.
There are two problems with believing that this is why the PBOC devalued: any rebound in exports will be on a 3-month lag; and the devaluing wasn’t significant enough to have major impact on exports themselves, or China’s economic growth.
There are a couple of risks to a weaker Yuan.
There is a risk of capital flight. It has been estimated that for every 10% depreciation in the Yuan versus the US Dollar, there would be a flight of capital equal to $400B. It sounds like a big number, right? However, when put in the perspective of China’s currency reserves, which stand at just over $3.6 TRILLION, China can afford to absorb the loss of capital, if they so choose. And the reality is that risk capital has already been leaving China, well before last week’s devaluation.
The other risks are that a weaker Yuan hurt the housing recovery and could further hurt the equity markets. You can send a currency to the depths of hell and it wouldn’t hurt an equity market more than a 1-month, 35% decline, which Chinese investors experienced in June. In fact, treating a currency like a Salem Witch, often has the opposite impact on an equity market.
I’m not saying that the devaluation is no big deal and that there might not be significant ramifications. I’m simply saying the key takeaway is not the things that everyone is talking about.
There are 3 concerns that the markets have as it relates to the devaluation.
The main concern from the market is what the devaluing says about the state of China’s economy. Anyone who pays attention, or reads TWR, knows that the Chinese economy has been slowing for months, which is why the PBOC has thrown everything at the economy that it can in terms of easing policies. It is also clear that those easing policies have not worked. The devaluation did not alert us to a deterioration in the Chinese economy; Chinese economic reports have already done that.
The second concern is the impact on commodity markets. A lot of people blamed commodity weakness last week on the devaluation. Have you seen a commodity chart lately?
Most major commodities peaked in 2011 or 2012. Sugar, corn, wheat, gold, silver, soybeans, cotton and of course, oil. These commodities have been declining for over 4 years!
Interestingly enough, so has China’s economy, if you look at the Big 3 data points: retail sales, industrial production and fixed asset investment. We received the latest round of data for these 3 series and it showed further deterioration.
But the trust is, all 3 of these data series peaked in 2011. China’s economy certainly plays a role in commodity pricing but this isn’t new news and last week’s devaluation didn’t tell us anything about the future of commodity markets that we didn’t already suspect, further downside.
The last concern is the risk of “currency wars” or “contagion” from the Yuan’s devaluation to other currencies around the world. I was out last week and I overheard a financial advisor from a major bank cursing “the Chinese” and blaming them for a 5% drawdown in his clients’ accounts.
If you lose 5% of your account in one day, you’ve got bigger issues than what the Chinese are doing, but I digress.
I always find this type of thinking interesting, if not hypocritical. What have the US, Japan and the Eurozone been doing for decades? Just look at a chart of the US Dollar or the Yen and you will see one thing, a currency that has been burning for decades.
The Eurozone is new to the party but even they have been at it almost 10 years themselves. So why do we single the Chinese out? I have the same rebuttal for those concerned about an Asian contagion. Have you seen emerging market currencies recently?
Most are sitting at 5-year lows, without last week’s Yuan devaluation. Korean Won, Thai Bhat, Turkish Lira, South African Rand, all are crashing. And I can promise you its not China’s fault. Nothing has had a larger impact on EM currencies than the strong US Dollar and the impending tightening in US monetary policy. That combination is kryptonite to an EM currency’s strength.
The Real Takeaways
Now that I’ve taken a hammer to all of the things the world is focused on, let me reveal what the real takeaways should be from last week’s devaluation.
I’ve already stated that the Yuan’s devaluation was too shallow to have any real economic impact but what it does signal is that the PBOC has shifted its currency policy, and this is a very big deal.
China had been keeping its Yuan strong in order to curb capital flows, wean China off its over dependence on exports and make a case for reserve status at the IMF. The devaluation suggests that the government is now focused much more on combating the domestic economic slowdown, which means that economic growth could be deteriorating more rapidly than the numbers show us.
It also means that more easing policies, such as RRR cuts and government bond offerings, are just around the corner.
Markets are global and inform one another, so stick to a global macro process that focuses on marginal changes in both asset classes as well as fundamentals. This will allow you to find profitable opportunities while everyone else is shock and awed by the media.