Posts tagged Currencies
This week’s financial news cycle has been all about China, and a wacky week it has been. On Monday major global equity indexes experienced their biggest pullback since January as trade tensions continued to fill up the Twitter feeds of the investor class and their trader bots. Not that it was all that much of a pullback: the S&P 500 was off a bit more than two percent, the Nasdaq a bit more than that. Predictably, of course, the mainstream news outlets chose to ignore the relatively minor percentage point drop and put up instead the screaming headline “Dow Plunges 600 Points!” “Six hundred” is sort of a big number, unlike “two percent” and so it had to be thus to maintain the focus of their audience for a few more minutes before they all went back to whatever this year’s Candy Crush diversion happens to be. Anyway, stock markets recovered as the week wore on though in a somewhat jittery state. But a potentially more consequential development was playing out a bit behind the scenes in the bond and currency markets. In numerological terms those developments played around the numbers seven and ten.
Unlucky Number Seven
The seven in question refers to the amount of Chinese renminbi that one US dollar buys. Right now the RMB/USD exchange rate is hovering above that threshold, at about 6.9 renminbi to the dollar. That’s not the lowest level for the Chinese currency since Beijing implemented a managed float system to replace the old fixed rate back at the turn of the decade, but it is close. The chart below shows the currency’s price trend over this period.
In the past, China has been accused of purposely undervaluing its currency in order to make its products more attractive to export markets. If that were the case, one would expect Beijing’s monetary authorities to be perfectly happy to let the renminbi fall below seven. The reality, though, is that currency manipulation of this sort has been out of favor for many years. Since the middle of the present decade China’s currency policy has consisted of two main aims: first, to open up the currency to a more prominent role in global financial flows in a manner more befitting of the world’s second largest economy; and second, to prevent massive capital outflows by domestic owners of renminbi-denominated assets. This second point, remember, was a major concern back in August 2015 and again in January 2016 when economic concerns sparked a wave of outflows. At that time Beijing commenced a sustained program of reducing their substantial holdings of foreign exchange reserves in an effort to bolster the currency – in effect, to keep the currency from falling below that threshold of seven to the dollar.
The Tenacious Ten
Which, in turn, brings us to the number ten, as in “10-year Treasury.” Because when talk turns to China’s store of foreign exchange reserves, the dominant asset in question is US Treasuries, the 10-year benchmark prominent among the spectrum of maturities therein. How important is it for China to support its currency above that seven threshold? Important enough to accelerate the pace of Treasury sales – perhaps goaded on by the parallel role such a move could play as a salvo in the trade disputes?
The good news is that a massive sale of Treasuries is probably not in the cards, at least not given the current state of things where China’s economic health remains relatively robust and the trade war is still more about posturing than actual infliction of damage. For one thing, it’s hard to think of a useful asset China could find to replace US government paper for its FX reserves. Japanese government bonds or German bunds? Those are similar in risk profile, but they also carry negative interest rates all the way out to the ten year maturity band. Nein, danke.
Nor is it even certain that substantial Treasury sales by the asset’s largest foreign holder would have a deep impact. The Treasury bond market is around $16 trillion in total size, of which China holds a bit more than $1 trillion in its FX portfolio. There is vanishingly little evidence of any widespread distaste for Treasuries among investors, many of whom expect Fed rate cuts in the next couple years and a general flight to quality sentiment as the global economy slows. That sentiment would likely attract plenty of buyers to any fire sale operation mounted by Beijing.
So that’s the good news. But it is also pretty clear that Beijing will try and do whatever it takes to prevent the kind of financial instability experienced in 2015-16, and a stable currency is a big part of that equation. The headlines may all be about bellicose trade war tweets (and they will no doubt continue to push and pull short term stock price movements), but there is much more going on with China that could play out in uncertain ways in the weeks and months ahead.
Pundits who follow financial markets are always ready to supply a narrative to the crisis of the day. “Stocks fell today because of X” is how the story usually goes, although “X,” whatever it may be, is likely only a strand of a larger fabric. These days market-watchers are focused on Turkey, and the “X” factor giving the story a human face is one Andrew Brunson, a North Carolina pastor who for the past two decades or so has lived in Turkey, ministering to a small flock of Turkish Protestants. Brunson was caught up in a 2016 political backlash following an attempted military coup, and has been detained on charges of collaboration (unfounded, he claims) against the Erdogan regime ever since.
Earlier this month the Trump administration anticipated Brunson’s release after protracted negotiations. Instead, the pastor was placed under arrest. The US responded with a new round of sanctions, including a 50 percent levy on imported steel. Team Erdogan dug its heels in. The currency collapsed and – voila! – the summer of 2018 now has its official crisis. For investors, the pressing question is whether this is an isolated event, or a larger peril with the potential to turn into a 1997-style contagion.
Shades of 1997
Once seen as the next likely candidate to join the European Union and pursue the traditional path to prosperity by linking in to the global economy, Turkey instead has become a dictatorship under Erdogan. Possessed of a less than perfect understanding of macroeconomics, Erdogan has doggedly refused to address the country’s currency crisis by raising interest rates, the normal course of action. Facing down external borrowing needs of $238 billion over the next twelve months, the regime improbably imagines relief coming from comrades-in-arms such as China, Russia and Qatar. These are Turkey-specific problems.
But currency woes are anything but local-only. Almost all major emerging markets currencies are having a terrible time of things in 2018. The chart below shows four of them, including the Turkish lira.
From this standpoint, the situation looks less like a simple tempest on the Bosphorus, and more like the summer of 1997. That was when Thailand, under speculative attack from foreign exchange traders, floated its currency and sparked a region-wide cataclysm of devaluations and stock market collapses. One of the issues contributing to the mess in 1997 was the vulnerability of countries with large amounts of dollar-denominated external debt – a falling currency makes it increasingly difficult to service interest and principal payments on this debt.
This is an issue of relevance today as well; indeed, countries with the largest non-local debt exposures have been hit hardest alongside the lira (see, for example, the South African rand in the above chart). Another theme of 1997 was current account deficits, a particularly important data point for countries where exports play a central role in growth strategies. That has been the driving force behind India’s currency woes this year (also shown above). High oil prices (a key import item) have raised India’s trade deficit to its highest level in five years. And, of course, the specter of a trade war looms over all countries active in global trade.
Sleepless in Shanghai
Arguably the biggest difference between 1997 and today is the role of China in the world’s economy. Back then the country was still in the early stages of the boom that spawned the great commodities supercycle of the 2000s. Now it is the world’s second-largest economy (and the largest when measured in purchasing power parity terms). China is currently dealing with its own growth challenges – very different from those facing trade deficit-challenged economies like India or near-basket cases like Turkey, but concerning nonetheless. The Shanghai and Shenzhen stock markets have been in bear market territory for much of the summer. China’s biggest challenge is managing the transition of its economy from the fixed investment and infrastructure strategy that powered those supercycle years into a more balanced, consumer-oriented market. That is the right thing to do – the infrastructure approach is not sustainable for the long term – but concerns about the transition persist even while the country putatively continues to hit its GDP growth targets.
So how much contagion risk is there? The main problem as we see it is not that the detention of a pastor in Turkey could bring down the global economy. It is that all these strands – debt exposures, trade deficits, growth concerns, trade war rhetoric – are percolating to the surface at the same time. The story is not as systemic as that of the ’97 currency crisis, where the same one or two problems could be ascribed to all the countries suffering the drawdowns. But with all of these strands front and center at the same time, we cannot rule out the potential for broader repercussions.
The ’97 crisis had only a limited impact on developed markets. US stocks paused only briefly before resuming their manically bullish late-1990s ways. So far, neither turmoil in Turkey nor sleepless nights in Shanghai are having much impact on things here at home. A little more volatility here and there, but stocks within striking distance of January’s record high for the S&P 500 (and still setting new highs when it comes to NASDAQ). But we’re closing in on the always-important fourth quarter, and need to be fully cognizant of all the different narratives, positive and negative, competing for attention as the lead theme.
Investors who went bullish on emerging markets equities in the immediate aftermath of the 2016 US presidential election must have looked daft to the conventional wisdom of the day. That wisdom (such as it was) saw non-US markets generally and EMs in particular being on the wrong side of the “reflation trade” – furious, price-busting growth in the US, a resurgent dollar and export-oriented economies left out in the cold by “America first.” EM investors who stuck to their guns got the last laugh. Since the beginning of 2017 the MSCI Emerging Markets index, a popular benchmark for the asset class, has appreciated more than 32 percent in local currency terms. The index has done even better in dollar terms (which is how a US-domiciled investor would tally her performance), largely because that anticipated dollar rally last year never happened, and EM currencies mostly rallied against the greenback.
Climbing the Wall of Worry
The first four months of 2018, of course, have produced a very different market for risk assets than the previous year. With all the clear and present fears of a trade war casting a pall on markets for the past two months it would be fair to say that emerging markets – prominent representative members of which are front and center in the trade war crosshairs – have had to climb a wall of worry. But for the most part climb they have, as the chart below illustrates.
EM equities took a big hit in early February, along with most other risk asset classes. But MSCI EM is still up by about 2.3 percent for the year to date (in price terms), which is better than either US large caps or most non-US developed markets. This, even though (a) the MSCI EM index is disproportionately represented by China and other Asia Pacific economies (more than 70 percent of the index’s total market cap) and (b) these very same Asian economies are central to the trade disputes making daily headlines. The relatively healthy recovery following the initial February pullback seems to offer persuasive evidence that investors do not ascribe a high probability to a scenario of all-out trade war. It also underscores some fundamental changes in global trade flows over the past decade. The old model of China and other emerging Asian economies largely dependent on exports of basic, low-value goods to the US is no longer valid. Trade flows are much more diversified, with an increasing percentage denoting trade among emerging economies themselves.
Additionally, Asia is now home to a larger number of world-beating companies domiciled in these countries, across a broad range of industry sectors including high value-add segments of research-driven technology like robotics, clean energy and quantum computing. Earnings prospects for these companies are strong, which keeps valuation levels from being excessive even after the strong growth of the past 16 months. In fact, regional forward price-earnings ratios in the low teens make for comparatively attractive value plays versus the current 17 times next twelve months (NTM) P/E ratio for the S&P 500.
A Rupee For Your Thoughts
Investors still have a habit of treating emerging markets as a single asset class, despite the fact that differences between the key economies in this group are profound. A look at some recent trends in currency markets illustrates that what looks at first glance to be a dominant directional play is actually driven by very different variables. The chart below shows the performance of four currencies: the Brazilian real, Turkish lira, Russian ruble and Indian rupee.
To paraphrase Tolstoy, each of these dysfunctional currency trends is unhappy in its own special way. Brazil’s woes are a mix of politics and technicalities in the currency swaps market. Russia took a hit from renewed concern over sanctions in the wake of the recent US missile strikes in Syria. Volatility in the Turkish lira stems from local geopolitics as well as concern over a potential forthcoming rate hike. India’s economy has been in something of a funk of late, and recently it was added to the US’s list of currency manipulators (at the same time that, surprising to many observers, China was left off).
These all being local rather than asset class-wide stories, there may be little about which to be concerned for investors in a broad emerging markets equity play like the MSCI benchmark. It’s also worth noting that China’s currency is not suffering the same fate as the four shown above: the renminbi has gained ground this year and held steady throughout the recent trade war posturing. Fundamentally, the EM story would appear largely to remain sound. But historical trends have shown that investor perceptions of EM flows can turn on a dime. Those four individual currency stories illustrated above could morph into a single narrative that the asset class’s fortunes are due for a turn and it’s time to get out. Not what we would recommend at present – but it’s worth keeping an eye on how this plays out.
There has been almost nothing “happy” about the New Year thus far. It’s probably a good thing that investors had a whole weekend in which to shake off New Year’s Day hangovers before showing up to face a sea of red arrows on Monday morning. Those red arrows, of course, came courtesy of yet another series of bafflingly inept moves by Beijing’s financial policymakers. It would be an exaggeration to say that the world’s second largest economy is in a swoon, but its financial markets certainly are.
But while the dramatic pullback in world equity markets and rising volatility are strong reasons to give pause, we do not believe this is the right time to pull the panic switch. While unquestionably a critically important component of the global economy, China depends on other world markets for its exports more than other world markets depend on China’s domestic demand for their own fortunes. Moreover, the fortunes of US companies still depend more on the US consumer than anything else. This year may provide a decisive answer to the question of whether the US economy can continue to prosper as the world’s growth engine despite increasing weakness elsewhere. We don’t yet know that answer – but based on the data we have on hand, we are not ready to jump into the lifeboats. If today’s environment bears any resemblance to past periods, we think more of 1997-98, and less of 2007-08. It is worth revisiting what happened back then before we conclude with our thoughts on the current market.
Asian Currencies, Act I
The Asian currency crisis of 1997 had an effect on equity markets around the world, including the US. The chart below shows the price performance of the MSCI All Counties Asia Pacific index from January 1997 to December 1998, versus the S&P 500 for the same time period.
The carnage in Asia was fast and brutal, with currencies falling as much as 40 percent against the dollar, and regional stock exchanges losing as much as 60 percent. As the above chart shows the S&P 500 (in green) suffered a rapid succession of pullbacks of 5 percent or greater between the summer of 1997 and January 1998 (the pullbacks are indicated in the chart along with the magnitude of each peak-to-trough drawdown). These pullbacks came on the heels of a near-10 percent correction that took place before the currency crisis. Many investors at the time interpreted this shaky performance – in the context of a deeply troubled global economy – as presaging an end to the bull market that had run nearly uninterrupted since early 1995. Asia was seen as the world’s emerging growth region, with great promise for US companies to manufacture, source labor and materials, and sell to the fast-growing middle class households in the region. The currency crisis threatened to bring a swift end to the good times and to provide a headwind to US companies’ EPS growth.
Russia Unleashes the Bears
As dire as the currency crisis was for Asian markets, which continued to fall through most of 1998, the US channeled its inner Taylor Swift and “shook it off” to rally strongly through the first half of 1998. Investors’ focus turned away from turmoil elsewhere to focus on the strength of the domestic US market, particularly the tech boom riding on the Internet’s penetration into commerce and social life. Then another foreign time bomb went off in August, when Russia devalued its currency and defaulted on its sovereign debt obligations. Another massive selloff took place in US equities – this one approaching the 20 percent threshold for a bear market. Caught up in the Russia collapse was the hedge fund Long Term Capital Management, which over the course of a tense few days threatened to turn this pullback into a genuine pandemic.
After all the drama, though, it turned out that the best way for investors in US stocks to navigate these two volatile years was to…do nothing at all. The S&P 500 registered a 66 percent cumulative price gain from the beginning of 1997 to the end of 1998. It was undoubtedly tempting to sell out at various critical junctures, but patience and discipline were rewarded.
Asian Currencies, Act II
Asian currencies are once again at the center of things. Most fell sharply against the dollar last year, though so far by generally less than they did in 1997. The Malaysian ringgit, for example, is about 23 percent lower versus the dollar over the past twelve months, and the Thai baht is softer by some 11 percent. Of course, this time it is the China renminbi – largely not a factor in the ’97 crisis – that is the center of focus. The RMB has devalued by just over six percent from where it was before the first bout of devaluation last August. What should not be forgotten, however, is that the renminbi was largely flat against the dollar in the first half of 2015, while the euro and other developed and EM currencies were falling.
Also worth remembering is that China as well as its Asia EM neighbors are in far stronger FX reserve positions today than they were in 1997. The threat of a debt default by any regional government is considerably more remote than it was nineteen years ago. China’s policymakers may demonstrate a tin ear when it comes to considering the likely short term impact of their decisions on world financial markets, but it is hard to imagine them making the kind of policy mistake that would trigger a real economic freefall.
And that brings us to China’s real economy. All the drama this week started with a below-consensus manufacturing report representing a fifth month of contraction. At the same time, though, recent indicators of consumer activity have been good – retail sales have been growing at double-digit rates for most of the last twelve months. If China’s economic transition is going to succeed, it is going to succeed thanks to the consumer, so these trends are absolutely consequential to the larger picture.
And if China does export price deflation to other markets through a weaker currency? Well, lower prices for China imports could be stimulative for US consumer activity. As we said earlier, what is good for the US consumer will likely be good for US stocks. Admittedly, this is a rational argument being made at the end of an irrational week. We may not be out of the woods as far as the current pullback is concerned. But we are not panicking.
Ah, yes, it is turning out to be another one of those unpredictable Augusts. US East Coasters woke up Tuesday morning to news of a major devaluation of the Chinese currency, the renminbi (RMB). Global asset markets then spent several days lurching this way and that as investors attempted to divine the meaning behind the sharply lower RMB reference rate set by the People’s Bank of China (PBOC), the nation’s central bank. As another summer weekend approaches, the preliminary consensus appears to be of the “tempest in a teapot” variety. Most bellwether asset classes have stabilized over the past forty eight hours. But investors heading back out to their boats and beach houses will likely still be pondering the Chinese currency’s near term prospects, and how this new twist adds to the brew of ingredients shaping possible Fed moves in September.
Market Adjustment or Currency War?
It is important to understand what did – and did not – happen this week. Every morning the Chinese monetary authorities set a reference rate for the RMB, and market makers are allowed to trade within a two percent range around that reference rate. Prior to Tuesday, the daily published reference rate had no explicit relationship whatsoever to market forces. There was no formula linking the reference rate to the previous intraday close or to perceived market supply and demand; rather, the reference rate was simply what the PBOC thought it should be.
Tuesday’s reference rate set the RMB at a level 1.9 percent below the previous close, and that announcement unleashed a flurry of pent-up selling pressure to take the currency down the daily maximum two percent from the morning rate. By the end of the week the net effect of the PBOC’s moves and market trading was a 4.4 percent decline in the value of the RMB versus the dollar. That was a move of a sufficient magnitude to push the topic of currency wars back into the discourse. However, the evidence so far does not support a clear-cut conclusion that China’s actions are motivated primarily by goosing up its export competitiveness.
Admission to the Club
Chinese policymakers this week pointed to the goal of a more tangible link between market forces and the RMB as driving the recent reference rate policy decisions. There is some convincing logic behind these statements. It is no secret that China would like to see enhanced reserve status for the RMB and a more prominent role for the currency in global trade and finance. An important milestone for this goal would be to have the RMB admitted to the elite club of IMF Special Drawing Rights (SDR) currencies, taking a seat alongside the dollar, euro, yen and pound sterling. Engendering more market transparency for the RMB is seen by many as a necessary box to check off for admission to the SDR club. Of course, proof that this is in fact China’s primary goal will require the People’s Bank of China to allow the currency to strengthen (thus weakening exports) as well as devalue when market forces so dictate.
Back to the Fed
Whatever the reason, a weaker renminbi is likely to factor into the calculus of the Fed’s forthcoming decision on whether to kick off its rate program in September. A rate hike that resulted in a sharply higher dollar, in the context of an already lower RMB, could have unfavorable economic consequences for US growth and prices. Such a scenario could give the Fed pause and push its decision back to December. The data would suggest this is likely, with recent headline GDP, employment and inflation numbers decent but certainly not indicative of an overheating economy. Alternatively, the Fed may simply want to get on with it and end the continual will-they-won’t-they chatter. If it does come in September, though, the rate hike may possibly be the most dovish ever.