Uncertainty Intensifies

China’s move to devalue its currency caught the markets somewhat by surprise. As a result, there has been a lot of speculation surrounding both the reasons behind the move as well as the implications of the move. I’ll try to cover some of the important points below. However, I want to acknowledge up front that the potential fallout from today’s news is by no means clear. The only thing that seems clear to me is that investors will now be faced with more uncertainty, which will likely lead to more volatility in the capital markets. Accordingly, our conviction in strengthened: the Fed will either delay the first rate hike or will do one symbolic raise for credibility purposes, and then pause.

Currencies
When people start talking about “currency wars”, it’s never a good thing. China’s move to devalue its currency could be the first shot across the bow towards a wider currency war (which some would argue was already underway in the form of monetary easing) across the world, and especially in the emerging markets. Why? Because the emerging market economies are highly dependent on exports, especially to China. So when South Korea’s currency strengthens against the yuan, for instance, it makes it harder for South Korean companies to export to China. The natural response is for South Korea (as well as other affected countries ) to devalue its own currency in an effort to maintain competitiveness. This can lead to a race to the bottom.

Traders’ initial reaction to the Chinese devaluation was to buy the dollar. Intuitively, this makes sense. If the Chinese (and others) want weaker currencies, it will come at the expense of the currencies that aren’t depreciating. The US dollar had already been on the rise on expectations of relatively strong economic growth as well as an impending interest-rate hike by the Federal Reserve. If currency wars intensify, it can be expected that the dollar will rise further. And then there’s the interpretation of China’s currency devaluation. Worries about sharply lower Chinese economic growth and the possible fallout from a currency war could cause a “flight-to-safety” trade into US assets and the US dollar, exacerbating the dollar appreciation. However, if China is indeed slowing dramatically and the dollar is rising, this will cause lower US exports and lower economic growth in the US. Moreover, if the dollar continues strengthening, the US will be effectively importing deflation at a time when the Fed is trying to induce higher rates of inflation. Lower economic growth and lower inflation might cause the Fed to defer the first rate hike, which would cause the dollar to depreciate. If you’re confused, you’ve got the right idea.

One final consideration with regard to currencies wars. It should be noted that devaluation by emerging-market countries poses substantial systemic risks in the capital markets. Emerging-market entities have issued a lot of dollar-denominated debt over the past few years in an effort to lower financing costs. If their currencies depreciate dramatically, it will get much harder to service this debt. A rush for the exits could cause a big problem across the debt markets.

Economic Growth
First, the obvious should be stated. China, the world’s second-largest economy and the engine of global economic growth over the past many years, is now facing a rapid deceleration in economic growth. Smart people can disagree about the real underlying rate of economic growth in China right now. From where I sit, it’s hard to imagine the export-dependent country is growing at 7%, which is the government’s target growth rate, when it just reported an 8.3% year-over-year decrease in exports for July. So, the first problem is that it’s getting harder and harder to defend the veracity of the economic data (and economic targets) produced by the Chinese government.

The second issue, in my opinion, is that historical growth rates in China, whatever the actual levels may have been, were heavily dependent on massive increases in debt (which seem to be understated by the authorities as well). So, if so much of the growth in the world’s second-largest economy has been a debt-fueled mirage, how are we to believe that China will remain the engine of global growth going forward? This is why it makes me very nervous when the Chinese take dramatic steps such as this. If 7% growth is not feasible, I would rather not see the Chinese try to hit that target at any cost.

Commodities
Despite large losses in energy and other commodities in recent months, the Chinese move to devalue the yuan is likely to lead to more price weakness. The obvious reason is that the move represents an acknowledgement that the economy is not growing as hoped. China has been the source of much demand for so many commodities in recent years. The tacit acknowledgement of below-target growth in the country will likely lead to sustained commodity price weakness in the months to come. Moreover, most commodities are traded in US dollars. Therefore, if the dollar continues to strengthen against the world’s other major currencies, it is likely to lead to further commodity price weakness.

Interest Rates
We’ve been saying for years that the economy is not strong enough to support sharply higher interest rates. We’ve also said that Fed interest-rate hikes are likely to come later rather than sooner. China’s move to devalue its currency increases our confidence that rate increases in the US across the yield curve are likely to remain contained. The first reason is that the inflation (with the exception of asset prices) is very low, and the low inflation, or disinflation, is likely to continue now that China is slowing dramatically. Whereas China had been hoarding commodities and other goods & services as it (over)built its infrastructure, the country is now dramatically reducing such purchases. But the productive capacity remains, leaving a situation whereby supply exceeds demand and prices are dropping.

Secondly, central banks across the globe have expressly used low interest rates as a tool to drive up the prices of riskier assets. Any meaningful increase in rates could cause a very destructive drop in asset prices. We are especially concerned with the effects of rising interest rates on the US housing market, which has played an integral role in the US economic recovery but has become highly dependent on ultra-low mortgage rates.

Finally, a portion of the drop in interest rates reflects risk aversion, or a flight to quality. As uncertainty increases, global investors are likely to be increasingly drawn to the safety of US Treasury bonds.

US Stocks and Earnings
To the extent that the Chinese devaluation reflects economic weakness in China, this will be negative for large US multinationals that do business in that country (and others affected by the currency wars). In fact, slower growth in China has been a common excuse for earnings and guidance shortfalls in the second quarter, especially in sectors with large international exposure like the Industrials. Companies in the Energy and Materials sectors are also negatively affected by the painful combination of slower Chinese economic growth and sharply lower commodity prices. As a result of the all the trends discussed, investors are likely to continue favoring US-centric companies with little exposure to a stronger dollar and slower emerging-market growth. We would caution, though, that companies that fit this bill have become quite expensive. And finally, it is likely that high-quality companies with competitive dividend yields will draw renewed attention yet again as we once again are staring at the prospect of a sub-2% yield on the 10-year Treasury.

Peace,

Michael