Yuan Yawn

by Jon Markman

Dear Constantin,

The Chinese yuan dropped in value three straight days until Friday, finishing the week with a 3% loss. Beijing authorities tried to stabilize the situation by saying the currency didn't have much reason to fall further. They also dismissed talk that Beijing was targeting a 10% devaluation, a figure that many Western economists argued is in store.
Are they right? Yeah, actually, you know, they might be. This time. For once.
U.S. and eurozone analysts are trying to figure out who will be worst hurt by the currency's trip-and-fall, which looked originally like an opening salvo in a mercantilist-style currency war, a last ditch effort to reinvigorate China's sputtering economy by spurring exports. But upon further review, a 3% to 5% deval is not going to help matters all that much. There might be something else going on.
David Rosenberg at Gluskin Sheff looked at China's main exports and compared them to other countries focusing on the same things. He found China's main exports are electric equipment, machinery, furniture, vehicles, clothing, medical/technical goods, plastics, and iron/steel products.
Germany had "the most vulnerability by far in this sense" according to Rosenberg, with the two countries competing in practically every export category. This was followed by Italy, France, and the Netherlands. India was vulnerable in clothing, as was Turkey. Mexico had exposure in furniture, machinery, cars, and electronic products. And Japan was vulnerable in cars, machines, and technical equipment. The United States — not so much.
To be sure, there are risks to the health of the global economy and markets if one considers the currency devaluation as a desperation play — a financial Hail Mary. Sarah Boumphrey at Euromonitor International finds that Asian economies near China are most at risk of economic weakness should a "hard landing" scenario play out in Hong Kong, Taiwan, and Vietnam.
Oxford Economics estimates that a 10% devaluation would have a "small positive effect on Chinese GDP, but is deflationary for other countries." Long-term implications revolve mainly around the accumulation of dollar-denominated debts. These become more expensive, which is a drag.
According to Hans Redeker from Morgan Stanley, short-term dollar liabilities in China reached $1.3 trillion earlier this year — equal to nearly 10% of Chinese GDP. Historically, in his words, this level of foreign indebtedness in emerging markets has been a "perfect indicator of coming stress." A repeat of the Asian financial crisis of the 1990s, if that's where we're headed, would hurt pretty much everyone. Duh, right?
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But hold on. Not so fast. Rosenberg dismisses the comparison. He notes China's currency was devalued a whopping 33% in 1994 — more than 10x what we've seen so far. And he doesn't believe China has launched a currency war either.
Rosenberg buys the idea that the devaluation was merely a market reform effort, that the Chinese government is mindful of their dollar-denominated debts and realizes a deeper devaluation would trigger capital outflows and destabilize sensitive Chinese markets. The IMF and the United States have both ganged up on China in recent years and begged it to let the yuan float. This week's activity could very well be a step in that direction. Like the old saw says, be careful what you wish for.

For now, I am taking the yuan out of my list of things to worry about.

Bottom line: For now it looks like fears over what China has done are overblown. And that's probably at least one reason that stocks rallied back on Friday and could very well firm up this week.
Indeed, analysts at Capital Economics believe all of this is part of an effort to get the International Monetary Fund to include the yuan in the Special Drawing Rights currency basket. They note that while the yuan "may fall further in coming days" the "bulk of the depreciation has already taken place."
I guess we'll see, but for now I am taking the yuan out of my list of things to worry about.
* * *
SUPER-REVERSALS
What a session on Wednesday last week! The S&P 500 sank a whopping 1.54% to lows at 10:30 a.m., then stabilized and slowly climbed higher and into the green by the closing bell. The rally from low to close was 1.65%. You'd have to assume that's a good sign, and perhaps a sign that the bottom for the recent excursion lower might be over. Yet history does not let us make that snap decision.
To answer the question, we turn to the data hounds at Bespoke Investment Group for their expertise and insights. They have an intraday S&P 500 price database that lists minute-by-minute price data for the index going back to 1983.
Bespoke analysts say it has been nearly four years since the S&P 500 had a day where it was down more than 1.5% in morning trading, only to finish higher on the day. The last time this happened was on October 4, 2011. That day was actually the bottom of the 2011 correction, and the index went on to gain 11.5% over the next month. But trading that day was much more extreme than it was on Wednesday, so don't draw a hasty comparison.
Bespoke says there have only been 42 days since 1983 in which the index fell 1.5%+ in morning trading only to finish higher on the day. These days are shown in the table above. Dates highlighted in green occurred during bull markets, while dates highlighted in red occurred during bear markets.
As you can see, there were a huge number of occurrences during the financial crisis of 2007-2009, with the first one coming about four months after that bear market started. Overall, the S&P 500 has averaged a slight decline on the day after these positive turnarounds, but the index has been higher only half the time.
Over the next week, the index has averaged a decline of 0.2% with positive returns 47.6% of the time. And over the next month, the index has averaged a loss of 1.31% with positive returns 54.8% of the time.
If you just look at the past few instances, or only instances in bull markets, this kind of action has certainly been a positive. But taking the longer perspective, the next move after a day like this is modestly positive, although the confidence level is not much more than a coin flip. So much for the conventional wisdom.
Best wishes,
Jon Markman