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What a lower yuan means for the markets

Surprise move: China unexpectedly lowered the value of its currency the yuan, last week

China finally joined the global devaluation bandwagon by announcing last week it was removing a longstanding peg to the greenback and allowing the country’s currency to decline in value.

The People’s Bank of China’s (PBOC’s) announcement caused the yuan, also called the renminbi, to last week suffer its largest two-day decline over the past twenty-one years. Despite the approximate 3 per cent drop in value, however, the currency still remains expensive on a relative basis having risen over 50 per cent against the currencies of its trading partners since 2005.

Although the PBOC stated this event was a one-time move to reflect market rates and make the currency more freely tradable, it comes after a slew of weak economic data including an alarming 8.3 per cent year-over-year decline in exports. This suggests the change was also intended as yet another Chinese stimulus measure.

The knock on effect of this landmark currency adjustment was to send the world’s major stock markets down sharply across the board. Last Wednesday, the Dow Jones Industrial Average was down as much as 270 points during the session before staging an afternoon comeback which essentially left it unchanged on the day.

The immediate implications of a lower yuan are to make Chinese exports more competitive and local stocks cheaper to foreign investors. However, reviewing the various policy measures made by China over the past several months adds greater perspective to their latest tactic.

In June, the PBOC announced its fourth interest rate cut over the past seven months in addition to lowering deposit-reserve ratios for many banks. The Chinese central bank cut the benchmark rate on one-year commercial bank loans by 0.25 percentage point to 4.85 per cent.

In addition to the interest rate cuts, the Chinese government has recently pulled out all the stops to prevent the local “A share” stock market from crashing further. After increasing in value by about 150 per cent since the summer of last year, the Shanghai Composite, a widely followed index of local share prices, began a sharp correction in mid-June which took the average down by about 30 per cent.

To prevent further damage to the “A” share market, the government took several extreme steps including freezing initial public offerings and other capital-raisings, authorising the government pension funds to buy equities, creating a government stock-market bailout fund, giving brokerages billions to buy-back stocks and allowing a proportion of its domestic-listed companies to suspend trading.

Some analysts have sharply criticised China’s intervention in the stock market; and yet other major countries, including the US have historically implemented similar measures when necessary. For example, during 2008 credit crisis, America bought up stocks on the balance sheet, used circuit-breakers to halt trading, restricted short selling and cut rates among other initiatives.

By now, it is no secret that China’s growth has been slowing. Economic factors impacting the world’s second largest economy include the need to unwind a portion of the country’s massive debt, a change in government policy to become a more consumption driven versus an export driven economy, rising costs which make it less competitive and a crackdown on the corruption which had likely been responsible for a misallocation of resources. In general, after many years of angelically high growth rates, China has now fallen back to real world status and must deal with the everyday challenges of debt, demographics and deflation facing many other large and important nations at this time.

Despite Asia’s new economic challenges and currency dislocations, these types of broad market sell-offs tend to create opportunities for those with patience and some free capital to invest.

For example, China’s slowdown could help cap future interest rate rises in the US as the Fed takes a harder look at its policies next month. In terms of asset classes, stable but higher income yielding securities look more appealing under the China slowdown scenario. Yet the greater question might be whether global stock markets can bounce back to new highs despite the outgoing red tide.

Before declaring that the global stock market is a screaming buy at these lower levels, I would point out that the Chinese economy is indeed an economic force to be reckoned with. My opinion in this case differs from the recent concerns over Greece which sent global stock markets reeling last month. By comparison, the Greek economy represents less than 2 per cent of Europe’s total economic output. However, with China we are considering a $10.3 trillion economic machine about 43 times the size of Greece. That said, babies are very likely being thrown out with the proverbial bathwater in the current market rout.

First of all, it would probably be unwise to say that China does not have the ability to forestall its current problems. With a base lending rate of just under 5 per cent, China still has plenty of fire power left to stimulate its economy even after the latest round interest rate cuts. Interest rates in most of the larger countries are sitting below one per cent and China could certainly move further in that direction.

Moreover, China has a one party system allowing it to move quickly and without much debate when necessary. A fast growing economy is needed to keep the country’s industry cranking and appease the masses. A soft landing is the most likely scenario, and it is unlikely that the 200 million or so Chinese who have recently entered the middle class sector are ready to start falling backwards.

The best investment opportunity here might be multinational companies with limited or at least manageable China exposure at current prices. For example, the Goldman Sachs auto sector analyst team stated in recent note they “think the market has already priced in more than its share of China risk.”

Other solid companies knocked about in the China bashing include leading cellphone maker Apple and the high quality Procter and Gamble company, maker of toothpaste and laundry detergent among other household items. P&G derives just eight per cent of revenues from China and yet has fallen over 15 per cent this year. Yum! Brands, the parent company of KFC, Taco Bell and Pizza Hut with 6,800 stores in over 1,000 cities in China, has also been beaten down. In words of my former mentor “people have to eat” and I would add brush their teeth too.

Bryan Dooley, CFA is a senior portfolio manager at LOM Asset Management Ltd in Bermuda. Please contact LOM at 441-292-5000 for further information. This communication is for information purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, investment product or service. Readers should consult with their Brokers if such information and or opinions would be in their best interest when making investment decisions. LOM is licensed to conduct investment business by the Bermuda Monetary Authority.