From time to time, clients ask what keeps me awake at night. My answer has been that while I struggle to identify the next black swan, a sudden and substantial devaluation of the Chinese renminbi has the potential to be a game changer in global markets. You might call this a ‘red swan’ event.
My answer is also based on detailed financial modelling from independent research providers, which shows that a material depreciation of the renminbi would shift growth from the rest of the world towards China, and deflation from China to the world. Overall, this would be a negative event for world economic activity.
Earlier in August, the red swan finally swam into view. Fortunately, however, it is a smaller swan than I had feared. While the sudden devaluation against the US dollar was a negative surprise for investors, the modest (3 per cent) extent of it leaves us with additional questions.
Was this a one-off measure, engineered by China to please the International Monetary Fund and gain access to the exclusive ‘Special Drawing Rights’ club? If so, no further weakness would be envisaged and there would be no further implications for world growth dynamics.
Or was this a pre-emptive action by the Chinese authorities, concerned that a Federal Reserve rate rise would lead to a further appreciation of the US dollar and, therefore, of the renminbi, managed under a semi-peg arrangement?
Under this interpretation, China would have concluded it was not willing to tolerate the effect on exports of a further rally in its currency. This would be a more dangerous development, as it could signal the start of ‘death by a thousand cuts’ for the renminbi – which could be poisonous for the world economy.
Performance of renminbi vs dollar over 3 months
Source: FE Analytics
Only time will tell, but we are following developments very closely. In the meantime, we can start to quantify the impact of the events of the past few weeks.
To date, even after the recent currency market moves, the renminbi still exhibits strong performance over the past three years (flat against the US dollar/sterling, +4 per cent against the Korean won, +9 per cent against the euro, +30 per cent against the Australian dollar, and +35 per cent relative to the yen).
The strength of the renminbi and the weakness of other world currencies has been a positive factor for the world economy, but a drag on China’s. It is now clear that the future will be different and that we will have to live without such a support mechanism. Will this cause major damage to the global economy, which is already suffering from stagnant global trade volumes and an anaemic revenue growth?
A disorderly weakness in the renminbi and a weaker global economy would ultimately also be bad for China. For example, large US dollar-denominated borrowings by local corporates do not allow much space for further competitive currency devaluations, as the cost of servicing this debt will become more and more costly. So we must assume that the magnitude of any further currency move will be carefully controlled by the People’s Bank of China.
The equity markets have recently corrected violently, interpreting the renminbi move as the signal of a deeper economic malaise in China. The truth is that China is trying to deal with a deep challenge to its economic growth and corporate profitability, and has recently deployed a series of policy tools and regulatory controls, with mixed fortunes.
Given the need to rebalance its economy, the use of the fiscal stimulus cannot be the main answer to its problems. At the same time, interest-rate cuts should be handled with care, because they could provoke further currency weakness. Further cuts in the reserve requirement ratio might represent the only viable option available.
We believe that the global economic situation has not been fatally compromised by the latest economic developments and currency changes in China, and that, notwithstanding the many issues already outlined, the world economy will still grow at a decent pace: the IMF forecast +3.3 per cent for 2015. The US, Europe and Japan will all benefit from certain specific drivers.
We have often discussed how resilient the US economy is, and how things are progressing in the right direction. Strong employment, a convincing resumption of lending, an improving housing market and good support from consumer spending are making us confident that the domestic drivers remain favourable.
Europe continues to see good data on consumption, good growth in monetary aggregates and strong commitment to quantitative easing. These factors should all underpin economic growth across the region. Some issues might arise in conjunction with the export sector and with emerging economies, but the data has so far been very resilient to the notable slowdown in emerging economic activity.
In Japan, we remain convinced that the ‘return on equity revolution’ is more than a temporary phenomenon. We see it as a secular change which will benefit corporate profitability, and the positive trend in earning growth and revisions continues unabated.
However, we do note that the approval rating for prime minister Abe has declined significantly, mainly due to his stance on the Self-Defence Force draft bill. This is seen as a key and necessary piece of legislation in the context of the alliance with the US and the struggle for supremacy in north-east Asia.
The time and effort spent on this controversial bill could be seen as a distraction from economic matters, but as the bill should be approved in September, we are confident that Mr Abe will be able to focus once again on Abenomics.
The encouraging picture provided by these three economic blocks is however offset by what is happening in many emerging markets. China is not the only problem area: resources-heavy Brazil and Russia continue to be affected by complex political issues and by persistent weakness of materials and energy. A series of economies in Asia have been severely affected by various other issues.
This brings us to the markets and their recent performance.
Performance of indices since 1 May 2015
Source: FE Analytics
Equity markets have been weak recently, affected by China issues, softer economic data and by a deteriorating technical picture.
However, we believe that profitability dynamics in Europe and Japan remain good, as earnings per share is growing at approximately 12 per cent in both markets, while valuations have become even more attractive.
Barring protracted strength in the US dollar and significant weakness in the renminbi, we believe the conditions for an extended equity market correction are not in place. Hence, we retain our ‘neutral’ stance on equities, with a positive bias in favour of Europe and Japan.
In our August meeting the strategic policy group have, however, downgraded the Asia equity complex to recognise the challenges represented by the current situation. Protracted outflows from these markets are impacting severely on their performance.
In the past, Q3 has tended to deliver a good dose of surprises and market volatility. History keeps repeating itself with the surprise appearance of the red swan in August, but the quarter isn’t over yet.
Marino Valensise is chairman of the strategic policy group at Baring Asset Management. The views expressed above are his own and should not be taken as investment advice.