Just one day after surprising markets by devaluing its yuan, the People’s Bank of China (PBOC) moved to weaken the currency again on Wednesday. These actions are the latest in a string of policy interventions designed to stabilize markets, support economic growth and manage China’s longer-term transition from an investment-led to a more consumer-driven economy.
While the overall size of this move is not massive, it does raise ripple effect questions that need to be considered. Both the timing and the implications of the currency adjustment create uncertainties about the state of emerging markets and what impact this has across other asset classes. The devaluation also raises a question about the timing of the Federal Reserve’s first interest rate hike in nearly a decade, which was largely anticipated by the market to be on track for September.
Here is what investors need to know about the current situation:
What happened?
On Tuesday, China’s central bank moved to devalue the yuan, cutting its daily reference rate by 1.9% vs. the US dollar. This triggered the biggest one-day drop in the yuan since January 1994. The PBOC also announced that future fixing will be based on supply and demand.
On Wednesday, the bank showed its commitment to the new policy of weakening the yuan by cutting its daily reference rate by another 1.6% as market forces showed further weakness in the yuan.
The devaluation heard around the world
Reaction to the devaluation reverberated across global financial markets with other regional currencies—including those in South Korea, Australia and Singapore—dropping 2% or more. Commodities declined amid implications about China’s growth and the impact a weaker yuan will have on imports by the world’s biggest consumer of raw materials.
Equity markets initially fell and worries about the increase in cost of consumer goods for Chinese buyers weighed on stocks with significant exports to China. Investor sentiment took a decidedly “risk-off” tone, and US Treasuries gained as both a safe haven asset and on fears of continued global economic malaise. German two-year bund yields fell to a record low on Wednesday morning.
Ripple effects for emerging markets and the Fed
While Chinese policymakers have indicated that the devaluation was a one-time adjustment, the broader view is that there may be a likelihood of further adjustments until the economic growth story has stabilized and currency markets settle. Indeed, the yuan has appreciated 12% in real terms since June 2014 so this shift is a small retracement of an otherwise strong move.
At a time when economic growth in China is the slowest in 25 years and recent export growth has been weak, one objective of this measure is to stimulate exports. The longer term benefit for China is progress toward internationalizing its currency. As China lobbies the IMF to include the yuan in its basket of reserve currencies (Special Drawing Rights or “SDR”), there has been pressure to move towards making the Chinese currency more driven by market forces, and this is a step in that direction.
But China’s economic slowdown has ripple effects for emerging markets, which will be hit by falling commodity prices, particularly base metals. This drag also extends to other developed economies including Australia, Canada and probably Japan.
China’s actions may also give the Fed pause as it relates to rate hikes. Concerns include the impact of a strong dollar on the US recovery and a potential decrease in US import prices, leading to a source of disinflation when the Fed is looking to cause inflation. These points have validity, but are likely marginal. Our main base case is that the Fed is still moving to raise rates in September, although it is clearly not a slam dunk decision.
Outside the monetary policy impact, this move will put downward pressure on commodities/commodity producers and impact large multinational companies that generate most of their earnings from outside the US, especially if those earnings are generated in Asia. Also impacted are European makers of high-end goods—the price of that Italian handbag just got more expensive.
5 short-term implications of the yuan devaluations
We remain cautious on emerging markets as a rising US dollar and the threat of higher US interest rates will keep many emerging market countries under pressure. Here are five potential short-term implications:
- Further capital outflows from China, as market participants may not believe this is a one-time event
- Further pressure on Asian currencies, which will adjust in alignment with the devaluation to keep themselves competitive
- A modest negative impact on emerging market bond spreads
- Continued demand for safe haven assets, such as Treasuries and bonds
- Continued dollar strength with interest rates and inflation to remain low
In the United States, a shaky bull market, the potential for higher rates, lofty stock market valuations and slowing earnings growth have made investors reluctant to add to equity allocations. Rather than continuing to buy the market, investors may want to evaluate industries that have been able to grow their revenues in excess of the overall market and nominal GDP. Regional banks and homebuilders are two such industries that may benefit from a Fed interest rate increase later this year.
SSGA also believes that given current valuation levels and potential headwinds from dollar strength, US equities are somewhat vulnerable. We see better value in Eurozone stocks as accommodative monetary policy and attractive valuations offer more room for profit growth.
This article was written by Daniel Farley, Senior Managing Director of State Street Global Advisors and the Chief Investment Officer for SSGA’s Investment Solutions Group.