So the boogie man exists and his name is China. A month before the Chinese President, Xi Jinping, is set to visit Washington to smooth troubled relations, an announcement has been made to devalue China’s currency. As you will see from the following descriptive paragraphs, this strategy helps the Chinese economy and hurts the U.S. economy. So just when economists began to feel good about the last two quarters of U.S. GDP, having dodged a Greek exit from the European Union and a weak first half in U.S. corporate earnings, along comes a faltering Chinese economy. Yet surprisingly, China has net foreign assets of 44% of GDP, and thus the weaker the currency, the richer China becomes. Although the Chinese economy is suffering from a credit bubble, a stock market decline, and a real estate bubble, the roughly 3% devaluation witnessed as of this writing could move to over 6% in the near term to stimulate the Chinese economy.
If devaluation was the only policy weapon being used, the net effect outside China would be negative. However, this move comes as part of a broader package of moves including liquidity injections, added fiscal stimulus and the prospective issuance of ¥3 trillion (Renminbi/Yuan = RmB/CNY) of development bonds. In addition, this move may make more rates cuts easier to implement (as the Chinese no longer have to support the currency to the same degree). According to analysts, if this entire stimulus package is to prove effective, in the medium term, housing values should stabilize. Housing is half of total household wealth of the Chinese citizenry. In addition, real estate is around 20% of GDP and 56% of bank collateral. The conundrum now is that despite recent weakness in Chinese export data, stabilization of housing in Tier 1 and Tier 2 cities is underway—an observation just two months old. If housing sales were to weaken, then we see little chance of a stimulus package working, even temporarily. According to Credit Suisse analysts, if housing prices in China fall 15% or more or deposit growth stops, then China would experience a hard landing.
The pressure on the Chinese government to stimulate growth in the near term is clearly growing. While official Chinese GDP growth statistics pointed to a modest pick-up in growth in the second quarter, the ‘real economy’ data, represented by indicators such as railway cargo, electricity production, car sales or copper imports are all at zero or worse in year over year terms. Moreover, nominal Chinese GDP growth is only at half of normal levels, while producer price deflation is running at -5.4% year-over-year. A weaker RmB could also add to inflation. This may not be a bad thing. After all, deflation is the bigger boogie man. He’s being fought around the world in Japan, Europe, China and the United States. Inflation has become a friendly metric for now.
On the international front, the devaluation of the Chinese currency is bad news. It is problematic for international companies competing against Chinese peers. It is also negative for people holding Australian dollars as 21% of new house purchases are by Chinese buyers. There is export exposure to people holding German car company stock as a significant portion of annual profits come from Chinese sales, despite the fact that only 2.5% of German GDP can be attributed to trade with China.
Is this likely to spark a meaningful retrenchment in risk appetite? The initial reaction from markets has been negative, but analysts doubt this marks the beginning of a more sustained risk-off trade for the following reasons: 1) This is part of a broader package of policies as noted above and there are some signs of near-term stabilization. 2) This could provide some cover for the Deutsche Bundesbank (German central bank) to remain dovish for longer. 3) At the margin, the modest deflationary impact of this devaluation could provide the excuse for central bankers within developed markets to be more dovish, especially the Bank of Japan (where, for example, our economists expect core inflation to end the year at 0.7% and wage growth excluding bonuses is only 0.5%) with 2.7% of GDP being exported to China. However, it is hard to see how this devaluation will have a big effect on the U.S. Federal Reserve policy with less than 1% of U.S. GDP being exported to China.
Meanwhile, as it relates to our U.S. equities markets, according to Credit Suisse analysts, in the aftermath of this abrupt Chinese devaluation announcement, “…gauges of investor optimism are not especially extended just now. While we admit that some market technicals have been worrisome (the loss of breadth or high yield spreads ex oil being close to 2013 highs), the bear/bull ratio (for individual investors) is close to lows which have been associated with market bounces. Moreover, we can see that risk appetite is not discounting a pick-up in US growth.” They go on to say, “…as a result, we would not turn more defensive.” Nevertheless, we have raised some cash and hope to reemploy this capital in more productive opportunities as an expected second half rally anticipates higher growth.
In summary, in close calls regarding risk and reward, I raise cash while deferring to an overweighting in equities when investor sentiment is significantly negative and therefore strongly contrarian. I therefore defer to the analysis that “…as a result, we would not turn more defensive.” That’s the thinking this month. I shall continue to closely monitor the Chinese economy, whether or not the Federal Reserve Board will set back to year-end a decision to raise interest rates, and much more. Please do call me if you have any questions as much has been covered this month. Thank you for your continued support and confidence.
Vaughn L. Woods, CFP®, M.B.A.
Investors should be aware that there are risks inherent in all investments, such as fluctuations in investment principal. Past performance is not a guarantee of future results. Asset allocation cannot assure a profit nor protect against loss. Although the information has been gathered from sources believed to be reliable, it cannot be guaranteed. Views expressed in this newsletter may not reflect the views of Bolton Global Capital or Bolton Global Asset Management. The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. VW1/VWA0208
Global Equity Strategy, Credit Suisse, A. Garthwaite, et al. August 12, 2015