Ask DWM: What Does China Devaluing its Currency Mean to Us?

Barron's Chinese YuanGreat question. Thanks. China is a very big deal. Much bigger than Greece (see DWM blog 6/30/15). China is currently the world’s second largest economy, about 60% of America’s GDP. It is expected to surpass the U.S. in nominal terms in 11 years. And, by 2050, China is expected to have a population of 1.4 billion (vs. the U.S. at 400 million) and GDP 50% larger than the U.S. For the last 25 years, China’s economy has grown at a 10% annual rate. In 2015, the growth is expected to be 7%.

China devaluing its currency last week came as a big surprise to many. In our blog of July 29th, we featured an article about the Big Mac Index with the Economist’s report showing that, on an adjusted basis, the Chinese yuan was undervalued by 9%. Until last week, the Chinese government’s strategy has been to keep their currency within a narrow trading band against the dollar. And, then last week, the news came out of Beijing that the country will now link it more closely to market forces. There were two major reasons.

First, they are trying to keep their growth and employment high. As we discussed in that July 29th blog, the WSJ Dollar index has risen 22% in the last 12 months. Since last December, the dollar index was up 9% as was the Chinese currency, the renminbi, otherwise known as the yuan. This meant that the cost of Chinese goods for people in the Euro zone, Japan, or the UK was 9% more than it was at the beginning of the year. As a result, Chinese goods have become more expensive abroad, as American goods have. And, this is hurting the Chinese economy big-time in growth and employment. Exports dropped by 8% in July. Furthermore, China experienced a stock market crash in the last few months as well.

One of the key tools that countries use when they are experiencing a downturn is to devalue their currency. Typically, this is what allows countries to stay competitive in the market place by making it cheaper for their customers to buy their products. Being tied to the USD wasn’t working. So, last week, the Chinese government allowed the yuan to become more market driven and it declined in value by 2%. At this point, it is difficult to determine what the future value of the yuan will be. The 2% is not in itself a big deal, but it may lead to a 10% devaluation or more (Barron’s August 15th). However, the linking to market forces is a big deal and represents the second reason.

China’s government wants its currency to become globally pre-eminent. They want the renminbi to be recognized as a reserve currency, along with the USD, the euro, the yen and the British pound sterling. Two weeks ago, Christine Lagarde, head of the IMF, said that the renminbi was not quite ready for inclusion in the basket of securities the IMF uses for “special drawing rights” because China needed to make its currency more “freely usable.” And the policy change last week, by moving to a more market based valuation, is a step towards inclusion.

So, what does the devaluation and potential slowdown in China mean? In the long-run, it’s tough to say. In the short run, it’s another source of concern and uncertainty for investors. Uncertainty and doubt has been the mood of the markets since March, when strong economic data in the U.S. caused the Fed to start talking about increasing interest rates. That uncertainty was followed by the uncertainty about a possible ‘Grexit’. And, now we’ve got China. At other times, the devaluation might have been seen by investors as good news- that China now is using a competitive tool to stimulate growth. But, instead it was received as another uncertainty, which, together with the other concerns have caused stock markets to go sideways for over 5 months now.

Here’s a great example: Apple stock. On July 21st, Apple reported quarterly results that were “amazing”- revenues up 33% and earnings per share up 45%. Yet, investors focused on the lower demand for the iPhone and the smartwatch not meeting expectations. Apple stock has dropped 11% in the last four weeks.

It’s a frustrating time for investors. Some are quick to start extrapolating that the last five months of flat markets may extend for years. It’s a frustrating time for wealth managers, like DWM, as well. However, we know, as Barry Ritholtz pointed out in his Bloomberg column last week, time is our investing ally. People are often stuck in the short-term, focusing on recent events and projecting those out for the future. Just because the markets have gone sideways for the last five months, does that mean they will continue to languish indefinitely? Yet, despite its lack of growth the last five months, the world stock markets have been up over 15% per annum since March 2009. In the last 40 years, including the dot.com bust and the financial crisis in 2008/9, a diversified, balanced investment portfolio has likely increased more than 7% per year.

We know that in the long-term that the power of compounding is in our favor. Yet, that mathematical concept can be difficult to accept emotionally at times like this. It is now one of our chief jobs as total wealth managers to stress that it is important to stay disciplined, stay focused on the long-term, stay invested and not let emotions drive irrational behavior based on short-term events.

The Debt Limit and Beyond

sterner queenMaybe we need a stern, bossy matron in D.C. to “kick some butt.” Barron’s pointed out Saturday that back in 1975, the Australian government shut down in 1975 over a budget impasse. Queen Elizabeth II (queen of Britain and Australia) came in and fixed the problem. She and the local governor-general fired the prime minister, passed a temporary funding bill, and held elections to replace the culpable Parliament. Australia hasn’t had another shutdown since.

Since that time, our American politicians have shut down our government 18 times. This time, the stock market seems to be treating the shutdown like the boy who cried wolf. Investors have seen this show before and the markets haven’t dropped. In fact, it appears that the current debacle in D.C. has some convinced that QE “tapering” is even further off, and therefore, it’s “a great time to buy.”

As we have pointed out in previous blogs, one of the greatest assets, if not the greatest, we have in America is the fact that Treasury debt is the only risk-free asset in the world. It’s the backbone of the world’s financial system. China and others invest their money in Treasury bills. Today, the U.S. dollar is not even close to being unseated as the world’s primary reserve and trading currency. Can you imagine how the world would be viewing our mess in Washington if the worldwide currency was not U.S. dollars? We certainly wouldn’t be borrowing 10 year money to finance our deficits at 2.70%. We might be paying twice that rate and increasing our annual deficits commensurately.

We’re all hoping that an agreement is put in place by October 17th. If not, the government loses its borrowing authority and it can only pay out the cash it has on hand. By the end of the month, that would mean the U.S. could miss a bond payment, which would create a huge mess. The banks rely on treasuries to trade with each other overnight. If you take away trust in the financial system or U.S. debt, it would be, as Joe Nocera on NPR Saturday expressed, “cataclysmic”. In Mr. Nocera’s worst-case scenario: “The banks would freeze up. There will be no borrowing. It’ll be like Lehman. The stock market will go down. It has the potential to be a real disaster.”

Certainly, we all hope and expect that our government will pull us through this short-term mess once again in the next couple of weeks. However, at some point in time, people worldwide may stop trusting the dollar. At that point, it will lose its advantage as the world’s only risk-free currency. Then, America will be on the same slippery slope as many countries around the world are today.

Yes, wouldn’t it be nice to have a stern, bossy matron to “kick some butt” in D.C.? If she isn’t coming soon, perhaps, as NYT writer Thomas Friedman and the Rootstrikers group have suggested, we should push for a third major political party. Two days ago, a Gallup poll showed 60% of Americans, disgusted with Washington, would support this option. Let’s hope it happens, sooner rather than later.