The pain trade brewing in emerging markets in recent weeks has gained more momentum.
Fear of escalation is the story for financial markets as China's currency weakened beyond a key level for the first time in 11 years. August is looking painful for investors as the long-running US-China tussle over trade and technology opens a new front via currencies.
Monday witnessed a major development for investors beyond the market turmoil unleashed by the renminbi weakening beyond 7 per dollar. What China has signalled is that there is no short-term trade deal or resolution at hand and its slowing economy requires help via a weaker currency.
This suggests a bigger equity correction looms as investors factor in a hit to global growth and corporate earnings. Even for Wall Street, the idea in some quarters that the US can win a trade war has fallen flat, with the S&P 500 index now having fallen more than 5 per cent from its record high of late July. Areas that had performed well in recent weeks such as technology and semiconductor stocks were hit hard on Monday, suggesting plenty of complacency over trade as a threat.
And the pain trade that had been brewing in emerging markets in recent weeks only gained more momentum on Monday.
First, a look at why the break of Rmb7 per dollar matters so much for global markets.
The People's Bank of China has fought hard in recent years to retain Rmb7 per dollar as a line in the sand, so Monday's action represents a shot across the bow in the US-China trade war. Indeed, President Donald Trump quickly used his bully pulpit of Twitter on Monday to make this observation: "It's called currency manipulation" while he sought a response from the Federal Reserve to help weaken the dollar. But the next Fed meeting is September 17/18, so unless equities and credit really fall apart, the central bank is on the sidelines.
The general market view is that the PBoC would not allow a disorderly decline in the renminbi, as it would raise the risk of capital outflows. Indeed, the PBoC said on Monday that it "has the experience, confidence and capacity to keep the renminbi exchange rate fundamentally stable at a reasonable and balanced level" while it blamed trade protectionism for the currency's weakening.
Still, as Alan Ruskin at Deutsche Bank notes, Monday's depreciation has made waves:
There is of course a strong argument for the PBoC to signal that 7.00 is only a number, and tolerate some FX flexibility. However, China did not have to let the currency weaken sharply so close to the Trump tariff announcement, in a way that leaves an impression that the currency is being used as a retaliatory tool for US actions on trade.
One good reason for limiting a weaker renminbi is that plenty of Chinese companies have US dollar debts outstanding, so a sliding currency only raises the cost of paying back such loans. Bottom line: currency weakness for China is not good for financial stability or for those foreign-based flows that have followed MSCI's inclusion of China A-shares in its benchmark EM equity index. It also heightens the pressure seen across EMs.
Charlie Awdry, portfolio manager at Janus Henderson Investors, says:
We are extremely cautious on the equity of any company with offshore debt financing in USD and HK [Hong Kong] dollars. A particular concern to us is property equities because the sector is a very large issuer in the high-yield offshore bond market. Indeed, over the years, this has traditionally been the Achilles heel of corporate emerging markets.
There has been plenty of conjecture that a currency war was brewing. That prospect now looks a lot likelier heading into August, a month renowned for market accidents due to thin trading conditions.
Looking back last year to another period of heightened trade tension from June to August, the renminbi weakened from Rmb6.4 per dollar to Rmb6.93 per dollar, just under an 8 per cent depreciation. A similar move would push the renminbi to about Rmb7.16 per dollar — that's the area currency traders are watching out for. Measures of implied volatility and options positioning suggest the market expects further weakness in the renminbi.
Brad Bechtel at Jefferies says:
Question now is how much they [China] push back, is this just a one-off shot across the bow or is this something more than that.
Monday's reaction was swift across global markets once the renminbi weakened beyond Rmb7 per dollar for the first time since 2008. Regional currencies such as the Korean won weakened sharply, MSCI's EM currency index was looking at its worst day in more than two years, while a resilient euro told us that carry trades were being unwound. Borrowing in euros and the yen to fund the purchase of higher yielding EM assets has been a trade that suddenly looks a little risky.
Citi's Dirk Willer advocates de-risking in EMs as the break of Rmb7 per dollar "may have a ripple effect on the markets' impetus to stay on high yield carry position". He notes a "sharp resumption in real money outflows last week, especially from Asia and Latam" and adds:
Further upside moves could shake up capital flows in China (acceleration of outflows) and global equity markets.
As the MSCI EM currency index tests its May low, so the MSCI EM equity index is also extending its recent run of declines.
During tumultuous times, investor tend to head for havens. The Japanese yen has found buyers, although heading below ¥106 per dollar is not good news for companies. Some are already jawboning about intervention from the Bank of Japan to help halt the currency's strength with ¥105 a floor.
Gold and government bonds are also purring. US Treasury yields dipped in Monday's mid-morning activity after US service sector data for July arrived below forecasts at its weakest level since August 2016. What was already an impressive rally in US yields this year showed no sign of easing up.
The US was not alone here. Among the various 10-year benchmarks, China's also fell to a new yield low for the year at 3.05 per cent — its benchmark has not been below 3 per cent since late 2016.
As for equities, one only had to look at the FTSE 100 index on Monday to see how clearly risk aversion was running the show with Fresnillo, the precious metals miner, standing out among FTSE 100 members.
More broadly, after both the FTSE All-World and S&P 500 indices suffered their largest weekly declines since last December, the current equity market correction still has room to run. The S&P 500 is heading for a test of its 200-day moving average at 2,790. This measure of momentum was briefly broken in early June and subsequently the market rebounded, buoyed by expectations of Fed easing that arrived last week.
Michael Wilson, equity strategist at Morgan Stanley, says:
From here, investors must decide if the Fed can deliver the growth needed to justify current or higher prices.
He believes:
The lesson is that while a change in Fed policy can affect financial conditions — and hence asset prices — almost immediately, reversing an economic slowdown with easier monetary policy takes time. Stay more defensively oriented in your portfolios until the slowdown is properly priced.
So, while the seeds of another buying opportunity are being sown, that may take a while to show up. Particularly if the global carry trade is carried out in the coming weeks as market volatility keeps climbing.
Aussie yen cross at a decade low — This currency relationship stands out as one of the most sensitive risk barometers, with the Aussie duly tumbling more than 3 per cent since Friday against the yen. This leaves the cross rate at its weakest level in a decade, below 72 per yen (outside of recent flash-crash episodes). With iron ore prices tumbling along with other industrial metals, the pressure is only building for the Australian economy.
US yield curve inversion — With the US 10-year Treasury yield plumbing 1.74 per cent (the lowest since October 2016) that keeps the difference between three-month bills and the 10-year note firmly inverted around minus 25 basis points, an area seen back in early 2007. This recession red flag has been waving in bond land for nearly three months, a period that historically meant the odds of a slowdown are high. The January 2020 fed funds futures contract implies a year-end rate below 1.50 per cent, having taken out the mid-June call of 1.60 per cent. The message for the Fed is that it risks falling behind the curve, rather than being able to take its time with a "mid-cycle easing adjustment".
Written by: Mike Mackenzie
© Financial Times
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