Our Portfolio Response to China's Devaluation
Tuesday, August 18, 2015
Last Wednesday, the People’s Bank of China (PBOC) announced a 1.9% devaluation of its currency, the largest in its history! The Dow Jones Industrial Average quickly plunged to a new low for 2015, down about 1.5% in just a couple hours! The dollar price of the 10 yr. U.S. Treasury bond rose +1.2% on the news, and European stocks closed down -2.7% on the day (London closes at 11:00 AM New York time).
HOWEVER, by the end of trading Wednesday, U.S. stocks recovered to “unch” for the day! Thursday morning, the PBOC held a press conference to say, “The Yuan adjustment is about complete, and rumors of a 10% devaluation are not true.” U.S. Stocks traded in a narrow range on Thursday and again Friday. Two questions come quickly to mind:
- Why would a small decline in the exchange value of China’s paper currency have a sudden but short-lived impact on world securities markets?
- What’s ahead for China, the Yuan… and the global economy?
For some enlightenment on the current Chinese situation, we have broken it down into the following 14 bullet points. (If you find this detail boring or depressing, by all means skip to our description of the silver lining for patient, prudent investors on pages 3 and 4.)
- China is a big player on the world economic stage. They are 1.3 billion people, about 4 times the U.S. headcount. During most of the last 20 years, their economy has been growing about 10% (real) per year… more than triple our growth rate. Now, with annual GDP of $10.3 trillion, their economy accounts for 16.7% of world economic output.
- China’s growth has been slowing the last five years, hitting a +7% pace in 1H 2015 despite government’s all-out efforts to stimulate consumer spending. The official 2015 economic growth target of China’s communist government has been 7.5%.
- Just since November, China cut interest rates four times, from 6.6% to 4.8%, in a clear effort to boost the economy by stimulating borrowing and spending. Now, 4.8% doesn’t sound low in today’s interest rate environment… but the outside world has little verifiable information about dealings in China’s government-controlled banking system.
- China has been lobbying to have their currency recognized by the IMF as a world “reserve currency," along with the Dollar, Euro, Pound Sterling, and Yen. BlackRock, Inc. estimates that such recognition could lead to a $1 trillion inflow into Yuan assets! In light of this aspiration, some interpret yesterday’s official devaluation as a somewhat desperate move, as it could postpone the likelihood of reserve currency status.
- A de-valued Yuan will increase China’s selling-price advantage vis-a-vis other manufacturers around the world. If -1.9% is just the beginning, as some think, the Yuan could become more of a concern here and in other manufacturing economies.
- Our stock market’s big immediate concern is that China’s devaluation could trigger devaluations by Singapore, Malaysia, Japan and Korea. Historically, competitive currency devaluations have a reputation for getting out of hand… creating financial chaos.
- Back in the late 1970’s when the IMF provided Brazil, Mexico and Argentina cash to pay their unmanageable debts, they forced them to make reforms favoring free-market capitalism. Most doubt that China would be receptive to IMF policies of that nature today… I doubt the IMF would make free-market policies a quid-pro-quo for endorsing the Yuan as a “reserve currency." After all, the (manipulated) Yen has that status today.
- Many free-world commentators on economic releases by China’s communist government tend to take the official data with a lot of salt. Since they assume that any bias in the numbers will favor the upside, the steady downtrend from 10% growth to 6.5% in May-June this year (the industrial sector) makes macroeconomic analysts wary.
- Marc Faber, well-known Swiss investor residing in Thailand, doesn’t think the Yuan devaluation is significant. It’s just one of the things you do in a centrally planned economy that needs revving up! But, he believes China’s GDP pace is closer to +1% or 2% than to the official +7%!
- There seems to be a growing body of opinion that China’s economic progress is overstated. If analysts around the world should begin to discount their formal 7% growth expectations, the IMF and others would have to further reduce their global growth forecasts… dimming earnings estimates for U.S. companies with an important international presence.
- The devaluation threatens to further strain relationships with Washington. Bilateral trade talks have already stalled. China is not included in Obama’s Trans-Pacific Partnership trade proposals. President Xi Jinping is scheduled to visit the White House next month, and some Senators have been outspoken against “currency manipulation." Add this to the current list of issues, including alleged hacking of U.S. Government personnel records and maritime skirmishes in the South China Sea. Coincidence?
- A weaker Yuan translates as a stronger Dollar. That means U.S. exports to China are now more expensive there (so we’ll probably sell less); and Chinese exports into the U.S. are suddenly even cheaper in Dollars, hurting U.S. manufacturers, lowering U.S. inflation expectations, and perhaps preventing the Fed from “normalizing” interest rate. Finally, a stronger dollar reduces the value of U.S. companies’ overseas profits.
- Why stop at managing the currency? The state-backed China Securities Finance Corp.’s official role is “to stabilize the market”! How’s that working for them? Well, from last October to this June, the Shanghai Composite stock index shot up from 2290-to-5178… a gain of +136% in 8 months! In the latest 2 months, it dropped -24%! On one recent day, it slumped -8.5%! Sounds like that agency’s challenge is Herculean, indeed. This doesn’t have much of a free-market feel, you say? Hmmm.
- These activities bolster suspicions in the rest of the world that the central planners in China are not as capable and sophisticated in managing economic affairs as they have projected. Remind you of any central bank of an even larger economy that has kept rates at zero for 7 years, hoping to stimulate real growth to 3%, and raise inflation to 2%? How’s that working out for them? (Hint: growth’s been 1.5% and inflation 1%.)
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“Informed Patience” turns challenges into Opportunities!
Our tedious 14 bullet points detail economists’ current worries that the Chinese juggernaut… a centrally-planned eco-system controlled by its Communist Party… may be losing steam. Here’s our boiled-down summary:
- The Chinese devaluation, interest rate cuts and stock market manipulation point to slower-than-expected growth in the world’s second largest economy.
- A resulting stronger Dollar and Euro may become a slight drag on the economic pace in the U.S. and Eurozone (together, 48% of the world’s economy).
- There is some possibility of a disruptive currency war in the emerging markets.
These are substantive concerns for investors in stocks and bonds anywhere in the world. And, as investors living, working and saving in the USA, it’s important for us to be realistic about all sorts of global changes that affect business, profits and investor psyche. (“Psyche” may seem out of place… but investors’ perception of the future is the main determinant of valuation for both stocks and debt securities.)
We ought never lose sight of the truth that democratic free-market capitalism has proven itself the most resilient and by far the most productive economic system ever… the only one to have delivered billions of people from a minimalist existence. We firmly expect it will outlast other temporary pretenders. We remain confident about long-term return prospects for investors in economies that embrace its principles.
We will not be surprised if a slower-growing and somewhat aggressive China proves disruptive to those with whom they trade. And, especially if it drags out, we will not be surprised if the optimism implied by today’s high stock and bond valuations in the U.S. starts to fade.
No one will get rich ignoring realities; actually we could get poor that way! But we believe that a portfolio built on sober expectations, especially about the possibility of lower valuations ahead, will get to take advantage of bargain prices when the air begins to clear. And it will!
FAI’s Realistic, Patient Portfolios
We understand that investor enthusiasm for stocks runs in cycles, and we are realistic enough to never pretend these cycles can be well timed. One cannot know from what depths a valuation cycle may start to rise, nor from what exact heights it will begin to correct.
But we can know when securities in general are very richly valued or significantly underpriced in historic context. So, what we can do is: when stocks are very expensive we strive to have a less adventurous commitment to equities; conversely, we can invest more boldly when they are “giving stocks away."
Currently, our equity allocations are on the light side, reflecting: high valuations, the potential for interest rates to begin rising, and a sturdy list of economic and policy threats to global economic health (see above!).
Overall, this is a time to be guarded, particular, watchful and patient.
How does that translate into our overall portfolio style? Besides keeping a lid on equity exposure, FAI’s other responses to the global uncertainties and rich valuations include:
- Rather than invest in broad stock indices, we choose to own stocks of financially strong and competitively well-positioned businesses… especially ones with credible internal improvement programs that are attractively-valued.
- Our bond portfolios emphasize short-term corporates and medium-term government maturities that give us decent cash flow yet flexibility to adapt to interest rates changes in either direction.
- We make an extra effort to see that clients identify near-term cash needs so we can have the appropriate amount of cash set aside.
- We are making an extra effort to harvest any paper losses to protect our realized gains from the tax man.
- We continuously research “alternative” investments where returns are typically independent of general stock and bond market trends. Currently, we own three such externally-managed funds… each with a different approach.
- As an “insurance policy” against the outside chance of real chaos in currencies and financial systems that are increasingly under government sway, here and abroad… we keep a modest investment in gold bullion and gold mining shares. If risks heat up, we can always increase this traditional hedge.
This memo contains the current opinions of the author, J. Michael Martin and FAI Wealth Management. These opinions are subject to change without notice. Any views expressed are provided for informational purposes only and should not be construed in any way as an offer, endorsement, or inducement to invest. This material should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. Past performance is not indicative of future performance. There is no guarantee that these investment strategies will work under all market conditions and each investor should evaluate their ability to invest for a long-term especially during periods of market decline. Investors should discuss any investment with their personal investment counsel. No part of this material may be reproduced in any form, or referred to in any other publication, without attribution.
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