China surprised nearly everyone in the financial markets when it devalued the Yuan last week. Although the move was relatively small (2.9% for the onshore rate and 3.7% for the offshore rate), what happens next is extremely important for global markets. If last week’s move was a one off, then the impact will be limited. If, however, this is the start of a 10% or more devaluation, the implications could be serious.
Taking a step back, we need to place last week’s policy change in perspective. We all know that the Chinese economy has slowed down in recent quarters. Official data does not give us a true picture, but the slowdown is probably much worse than the authorities would like. To try and stimulate the economy, China has followed the usual policy mix. First, interest rates were cut and then reserve requirements were cut. At times, targeted liquidity injections were used and it would appear that infrastructure spending will be ramped up as well. With all this stimulus in place, surely the economy would have started to recover soon anyway? Why did they resort to what could easily be viewed as a controversial new policy and possibly a sign of panic?
We also need to recognise that in real terms, the Chinese currency has actually been incredibly strong as can be seen in the chart below from the BIS. During the last cycle, the major currencies have all seen periods of currency weakness, with the Euro down by 20% in the last 14 months and the Japanese Yen down by over 60% in the last three years. Emerging market currencies, some of whom compete directly with or trade with China, have also been weak in recent months. Perhaps China has just had enough and believes that it needs to weaken the Yuan to remain competitive.
The timing of the move, coming days after a very poor trade report showing exports down 8.3% year on year, was also very interesting. The chart below shows the performance of exports for China, Taiwan and South Korea which have generally been on a slowing trend. With no signs of a sustained pick up, and with other Asian currencies finally beginning to weaken, China appears to have had enough. Although the stimulus in place will help their export sector to a degree, they have chosen to start weakening the Yuan. Assuming that this is a deliberate policy objective, we have to assume that the trend now will be towards further currency weakness over time.
Of course, we could be wrong here, and the benign story is that China is simply moving to a free floating exchange rate which may not involve any depreciation at all if it is fairly valued. However, if we are right, the currency should fall by quite a lot. Yuan weakness is just another ingredient for a full blown emerging markets crisis along with weak global growth, falling commodity prices and liquidity outflows as global investors retreat back home.
Furthermore, debt levels (in China especially) rose dramatically in the last cycle and those who borrowed in US Dollars will be at real risk as their currency falls. History never repeats, but it does rhyme, and the parallels to the 1997 Asian crisis are striking. What is more, the Japanese Yen depreciated by nearly 50% in the two years before the 1997 Asian crisis, with some commentators believing that this was one of the tipping points for that crisis. So, the more than 60% depreciation in the Japanese Yen since 2012 is yet another sign of potential troubles for Asia as a whole.
How does this all relate to the global economy? Well, currency devaluations are basically a zero sum game. They are in effect a transfer from one set of economic agents to another, and in the case of countries that are suffering from deflationary forces, currency weakness will effectively “export” deflation. There should be little doubt that the strong Dollar in the last year or so has been a headwind for the US economy and US companies that operate globally. So the question here is can the US handle further currency strength if China adds to the deflationary forces from abroad?
The vast majority of pundits dismissed the Q1 weakness in the US, and although the Q2 rebound was modest, the consensus is very comfortable with the theory of a second half pick up. Indeed, forecasts are for 2.7% and 2.8% in Q3 and Q4 after 0.6% and 2.3% in Q1 and Q2. However, mainstream economists have a poor track record of forecasting, and the Atlanta Fed model seems to have become the most accurate of all. Yes, there are issues with such models, but at the moment, it seems that the Atlanta Fed is an accurate predictor of growth in the final weeks of each quarter. As can be seen below, this model is predicting growth of only 0.7% in Q3, way below consensus.
Assuming the Atlanta Fed model is correct and Q3 GDP growth is only 0.7%, then the year on year growth rates for the US economy will be about 1.5% real and 2.7% nominal. This is basically stall speed at a time when the Fed is thinking of raising interest rates after the biggest monetary policy experiment in history.
As well as another burst of deflation coming from overseas, the weaker oil price presents another threat to the important energy sector. Furthermore, we have shown before how the business investment component of GDP is the most volatile, and how corporate profits lead business investment which is the swing factor between expansion and contraction. With corporate profits (via the national accounts with data up to Q1) stagnating, and revenues (as per corporate accounts) falling for two consecutive quarters year on year, we should not expect a huge pick up in US growth. Indeed, looking at the chart below, we would argue that very high levels of inventory need to be liquidated in the months ahead.
In recent weeks, we have highlighted how we see parallels to both the 1997 Asian crisis and the 2007 peak prior to the financial crisis. A sustained period of weakness in the Chinese Yuan will only add to the global troubles. As we have said recently, the emerging markets appear most vulnerable in the months ahead and the possibility of a full blown crisis will rise in the event of Yuan weakness. Prospects for the US economy may not be as good as the consensus believes and the last thing the US wants is a weak Yuan, leading to an emerging market crisis that will eventually export deflation to the US.
We continue to believe that a tactical and very defensive strategy is best suited to the environment we see at the moment. Equity markets are vulnerable to steep declines, emerging market assets should be avoided and high quality assets with strong income potential should perform well. It is possible that Japanese and European equities will outperform because of their QE programmes, but these have become very crowded trades. If global investors really do become risk averse and want to liquidate assets, these two markets may also be vulnerable. Suffice to say that if the bearish scenario does play out, the Fed is not going to be raising rates. In this event, US interest rates and bond markets should perform well for a few quarters despite being overvalued.