China's Premier Zhou Enlai was asked in 1972 about the political consequence of the French Revolution, and he famously quipped it was too early to say. Even if, as historians recognize, Zhou was referring to the unrest in 1968 rather than the 1789-1799 revolution, it offers insight that is too valuable to let the facts distort.
Indeed, that insight offers good counsel now. While there is no substitute for prudent and disciplined risk management, we should avoid jumping to hasty conclusions drawn from the volatile price action.
Markets are incredible aggregators of information. They are also anticipatory by their very nature. However, they do not always anticipate correctly. Indeed, they often overshoot, and can transition quickly from a small gradual adjustment to a lurch, with little if any warning.
Markets are prone to exaggeration. Many participants appear to believe that the 2.8% decline in the yuan is some kind of watershed for the world economy. It, more than any other factor, has been blamed for the large sell-off in global equities. To wit, Bloomberg: " More than $3.3 trillion has been erased from the value of global equities after China’s decision to devalue its currency spurred a wave of selling across emerging markets."
The yuan has fallen 2.8% since the announcement on August 11, and that was recorded mostly in the first couple of sessions. Last week, as the stock market tumbled, the yuan traded sideways, and if anything, firmed slightly. The magnitude of the yuan's decline is too small to have much impact on Chinese exports. This, of course, can change going forward, but there is no reason to think that it is particularly likely. The IMF and the US embrace what PBOC said it is going to do. Their caution is prompted by concerns that China will not enthusiastically implement its verbal declarations.
Consider other currency moves since August 10. The Japanese yen has appreciated by 2.1%, the euro by 3.3%, the Swiss franc by 3.9% and the Swedish krona by 4.0%. The South Korean won fell 2.6%. Economists recognize these movements as too small to impact growth or competitiveness.
Some observers and reporters claim that Vietnam's currency depreciation, and the decision to float (sink) Kazakhstan's tenge was a consequence of China's currency move. It is asserted as a fact, but there is no evidence. The media does not quote officials from either country explaining such motivation.
Vietnam depreciated the dong twice before China's move. The only connection with China's currency move is that it took place prior to the third move by Vietnam. The larger concern for Vietnam may be the slowing of Chinese growth not the 2.8% decline in the yuan. This, more than the currency, explains the decline in Chinese auto sales, cell phone purchases and luxury goods consumption.
Kazakhstan is Asia's largest oil exporter. Of its exports, commodities make up the highest share, in fact one of the highest in the world; nearly 90%. Oil accounts for a little more of Kazakhstan's exports. It had a rigid currency regime. It has been under chronic pressure, even before the collapse in oil prices. It had devalued by nearly 20% in early 2014.
A more compelling narrative for Kazakhstan's decision to float its currency links it to the rigidity of its regime in the face of incredibly powerful terms of trade shock. The drop in oil cannot be directly attributed to China. The most recent trade data show that the economic slowdown has not weakened China's demand for oil. Kazakhstan Prime Minister, Massimov, linked his decision to oil prices, not to China.
The terms of trade shock referred more to Russia than China. Most of the country's imports come from Russia. The depreciation of the ruble cheapens the price of such imports. The ruble has depreciated 9% since China devalued.
Unlike Kazakhstan, China's devaluation was self-imposed. China chose to weaken its currency. It was not forced upon the government. Many in the (currency) war camp focus on the depreciation. Instead, the (potentially, if operationalized) more important aspect of its decision was in letting market forces steer the yuan. Chinese officials have recognized the need for greater financial reforms. The pressure is both internal and external.
The IMF's recent staff paper recognized the immense progress that China has achieved over the past several years. However, it argued that more efforts are needed if the yuan is going to be part of the SDR. Investors learned last week that the IMF board accepted the staff recommendation to delay to 1 October, 2016 any decision that the board makes on the yuan to later this year. In addition to making the currency regime more flexible, at least on paper, it also can better generate a real market price that is operationally necessary for setting the SDR prices, which was not produced by the former regime.
The timing of the PBOC move may have been linked not only to the IMF decision but also to next month's FOMC meeting, at which 82% of economist expect the first rate increase since 2006, or at least they did earlier this month (Wall Street Journal survey). Efforts to close the gap between the fix and spot prices, one of the declared goals of the new regime, would probably have been more arduous if the Fed were to raise rates first.
Because China allowed a small depreciation of the yuan, making it not weak but less strong (against most other currencies), many argue that it precludes a Fed hike. The Fed keeps its own counsel. Policy is not necessarily set as the IMF wishes. It is surely not set in Beijing. While it is perfectly reasonable that financial conditions are broadly taken into account in the setting of monetary policy, monetary policy cannot be a slave to the VIX either.
Just like the Fed has noted that expectations for higher rates in the US have helped strengthen the dollar, it may have also left equity markets, where Yellen has acknowledged elevated valuation, vulnerable to a setback. This is borne out by the fact that it has been trading in such a tight range which has prevailed for so long. The duration of such a narrow range is rarer than the S&P 500 falling nearly four standard deviations away from its 20-day moving average.
The key to stabilizing the markets may not lie with data. The more significant unknown is not that investors lack a strong handle on the state of various economies. The most important missing piece is the intent of policy makers. What is China thinking? Are officials panicking? What is the Federal Reserve thinking? Can it go against what the market is telling it via bond yields and break-evens?
In the US, the most important news then may not be the upward revision in Q2 GDP to 3.2% from 2.3%, according to the Bloomberg consensus. It may not be the durable goods orders report, where a sharp drop in aircraft orders will depress the headline. Personal consumption, a wider category than retail sales, is expected to rise 0.4%, which would match the three-month average. A 0.1% rise in the core PCE deflator may be sufficient to keep the year-over-year rate steady even if not strong at 1.2%.
While the media fanned ideas that the sharp drop in equity prices was a sign of fears of a global recession, the Atlanta Fed GDPNow estimate of Q3 GDP nearly doubled from 0.7% on August 13 to 1.3% on August 18. As more economic data is reported, the Atlanta Fed's GDPNow model is adjusted. It is nowcasting, not forecasting. The challenge for the FOMC is not the full employment mandate but the price stability mandate. That is why the more important event next week (August 29) is the Fed's Vice Chairman's panel discussion at Jackson Hole on US inflation developments.
We would not look for Fischer to break new ground, but rather to cogently explain how the Fed targets core inflation, and why the appreciation of the dollar, and drop in commodity prices, have a transitory impact on the general price level. The Fed attempt to focus on the underlying signal of prices. There are lag times between the change in monetary policy and impact on prices. It is true domestically as well as internationally—the price of money adjusts much faster than the price of goods and services.
The breakdown of UK's GDP data helps illustrate this point. The 0.7% quarter-over-quarter growth reported for Q2 is subject to revision. It is expected to be unchanged, but there is a small risk it is downgraded slightly. The details are expected to show that UK exports rose 2.0% in the quarter. This is remarkable. Many countries, including Japan and South Korea that have experienced weakening currencies, reported a decline in exports in Q2. In Q2, sterling was the strongest of the major currencies, gaining 6% against the dollar.
News from Europe will likely reinforce the view that the best of the cyclical recovery may be behind the eurozone. The composite PMI has been going sideways since March. Nearly every member reported weaker than expected growth in Q2. Germany's IFO is expected to have softened, dragged down by the weakness of the DAX, China's stock market sell-off and yuan depreciation. Other EC confidence indicators for the region likely weakened as well.
As with the real economy, so too with monetary measures and inflation. Money supply growth has stabilized though credit growth appears to be continuing to improve slowly. Germany and Spain's HICP measures of inflation are expected to have slipped lower.
Japan's data cycle sees several important reports in the coming days. These include household spending, unemployment, and inflation. The general sense is that the contraction in Q2 will not be repeated, but despite the BOJ's aggressive, unorthodox easing of monetary policy, deflation has not been defeated.
Investors should not focus on the headline CPI figures, or even the traditional core rate, which excludes fresh food. Although this latter measure of inflation is what the BOJ targets, it is clear from public comments, and confirmed privately, that key officials may be more focused on the measure that excludes food and energy (and alcohol). That measure is expected to be unchanged at 0.6%.
Our analysis suggests that the market has exaggerated the risk of a global recession and the competitive implication of the depreciation of the Chinese yuan. The sharp sell-off that has pushed the prices of almost 60% of the S&P 500 members more than 10% below their peaks will create new opportunities. Prudence dictates waiting for a technical sign that the momentum has exhausted itself. In particular, be on the lookout for one of a number of reversal patterns which usually entail a sell-off followed by a strong close.
The same is true of the dollar. The short-covering squeeze has lifted the euro and yen. Given market positioning, there is room for additional gains. However, these gains should be seen as counter to the underlying, fundamentally driven trend based on the divergence of monetary policy. This is the kind of pullback in the dollar than many investors had wanted in order to create a new opportunity to get with the trend and adjust hedges. Such participants should await a sign from the price action itself that the short-squeeze is over.