Currency Wars Revisited

February 9th, 2016

Since mid-2014, when investors began to anticipate eventual Fed tightening, the U.S. dollar has surged against most currencies.  For a while, China was one of the few holdouts that kept its currency tied to a strong dollar.  However, the Chinese authorities wavered last August, when they widened the band for the renminbi (RMB), and allowed it to depreciate by 2% against the dollar.  Reports in the media heralded it as the biggest devaluation of China’s currency in two decades, and pundits claimed that it threatened to lead to an escalation of “currency wars.”

Since then these fears have increased further as the Chinese authorities announced in December they would henceforth peg the RMB to a basket of currencies, and the RMB subsequently weakened against the dollar. This past week, moreover, the Bank of Japan surprised market participants by announcing it would begin imposing a negative 0.1 percent interest rate on any new excess reserves beginning on February 16.  The announcement caused the yen to depreciate against the dollar, and it has raised concerns that other central banks in Asia might be compelled to respond if the yen continued to weaken.

Some observers contend the situation could lead to a series of competitive depreciations such as occurred in the 1930s, when countries abandoned currency links to gold, intervened in foreign exchange markets to drive their currencies lower, and in many instances imposed restrictions on international trade.  However, my contention is the circumstances today are different in one important respect:  Namely, most countries have not been selling their currencies in the foreign exchange markets to weaken them; on the contrary, most have allowed market forces to determine the value of their currencies. Read the rest of this entry »

Is This China’s “Minsky Moment”?

January 29th, 2016


  • Do recent developments herald the bursting of a bubble in China’s economy that will presage a hard landing? While some observers believe the plunge in China’s stock market and in oil prices could signal such an outcome, these developments are not a reliable gauge of what is happening to the economy, where recent data are mixed.
  • The stock market sell-off occurred as a ban on sales of equities by large institutions that was set to expire was subsequently extended, and it is more an indication of loss of confidence in China’s policies. The recent drop in oil prices, moreover, appears to be mainly supply-driven, rather than demand-driven.
  • The risk of a hard landing would arise if property values were to plunge, as real estate is an important source of household wealth and it is also where banks have considerable exposure. However, the latest data does not indicate this sector is about to roll over.
  • Finally, in my view investors should be paying greater attention to Brazil, where the risk of a full-blown crisis continues to rise. 

Background: What’s Behind the Recent Market Upheaval?

For those who like drama, it’s hard to conceive of a more auspicious beginning to a year than a plunge in China’s stock market and pressures on the yuan reverberating around the world, and culminating in oil prices falling below $30 per barrelThe most common interpretation is these developments could indicate a significant slowing in China’s economy.  However, my own interpretation is that the market pressures are indicative of an ongoing loss of confidence in policymakers, which is evident from the sizable net capital outflows over the past year, which are estimated to have been in the vicinity of $1 trillion. Read the rest of this entry »

2016 Outlook: Growth Divergence to Continue

January 25th, 2016


  • The U.S. economy overcame a slowdown abroad and a strong dollar last year, while the unemployment rate dropped to 5.0%, which enabled the Federal Reserve to begin tightening monetary policy while Europe, Japan and China eased policies. This pattern will likely continue into 2016: The U.S. appears poised to grow above the 2.2% trend since mid-2009, while only modest improvement is expected for Europe and Japan, and China’s economy appears considerably weaker than the official growth target of 6.5%.
  • Financial conditions tightened somewhat in the past year, but they remain supportive of overall growth, and corporate credit spreads could narrow if default risks priced into markets prove excessive. U.S. equity market returns could stay subpar for a second consecutive year, however, as profit growth appears sluggish.  Following two years of strong appreciation, the U.S. dollar’s rise in 2016 is likely to be more muted, with the focus shifting to pressures on China’s currency.
  • One risk to the forecast is the possibility that problems in energy/mining could intensify and result in more widespread defaults if oil prices fall further. In the emerging markets, the key issues are whether China’s slowdown will remain gradual or intensify, and whether Brazil can avert a full-blown crisis. One of the main uncertainties in Europe is how it will cope with the influx of refugees from the Middle East.

The U.S. Economy’s Underlying Resilience

With the U.S. economic expansion now six and one half years old, a natural question is how much further it has to go, especially considering that the Fed has begun to tighten monetary policy when growth in other parts of the world is either sluggish (Europe and Japan) or slowing (China and other emerging economies).  While some observers are fearful that Fed tightening is a mistake and will ultimately be reversed, our take is that the U.S. economy is on solid footing, and the expansion is likely to continue for several more years. This conclusion reflects three primary considerations: (i) inflation is not an immediate threat that will cause the Fed to tighten policy precipitously; (ii) financial conditions remain generally supportive of the economy; and (iii) the economy is well diversified and not heavily reliant on demand from abroad. Read the rest of this entry »

The Slowdown Abroad: Implications for the U.S. and the Ongoing Risk of Bubbles

December 16th, 2015

Impact of the Slowdown Abroad

The backdrop for this topic is the worries investors had about a slowdown in China and Emerging Market Economies (EMEs) that resulted in the first stock market correction in four years in the third quarter. While risk assets have rallied since then, investors are uncertain about the outlook considering how sluggish profit growth has been amid weakness abroad, plunging commodity prices, and a strong dollar.

I will begin by observing that historically the U.S. economy has had greater influence on overseas economies than vice versa: The catch phrase “When the U.S. sneezes the rest-of-world catches a cold” is well known. The prime exceptions have been oil price spikes, which have been accompanied by recessions.

Regarding the current situation, the U.S. economy is holding up fairly well to the slowdown abroad.  This is evinced by the improving jobs picture, solid growth in the services sector, and the likelihood the Federal Reserve will begin to tighten monetary policy at the upcoming FOMC meeting. What makes our economy so resilient to developments abroad is that it is highly diversified and not heavily reliant on exports as a growth engine.  Thus, while China is the world’s second largest economy (and fastest growing), U.S. exports to China are only 1% of our GDP. Read the rest of this entry »

Recent Rumblings from China

December 10th, 2015

Risk of a Sino-U.S. Conflict

Normally, I confine my prognostications to assessing economies and markets, rather than geo-political developments.  However, a recent Bank Credit Analyst (BCA)[1] report on the topic of potential conflict between China and the U.S. is worth sharing.  The essence of BCA’s argument is that most investors believe the prospect for conflict is low, because both countries have too much to lose. However, the authors contend several developments have increased the risk of conflict.  These developments include China’s desire to expand its regional clout, while the U.S. continues to pivot to Asia by expanding agreements such as the Trans-Pacific Partnership Treaty (TPP), and Japan is remilitarizing in the wake of disputes over territorial claims in the South China Sea.  I do not claim to be an expert on these issues. However, one thing is clear – namely, China’s leader, Xi Jinping, is the most powerful since Deng Xiaoping and is more assertive in both foreign and domestic affairs than his predecessors.

In these circumstances, it is imperative that the U.S. government have a clear stance on what is vital to our interest and what is not, and I will highlight the need to get our stance on trade policy and exchange rate policy right.  This issue first surfaced in the mid-1980s when Japan ran large bilateral trade surpluses with the U.S., and U.S. officials accused Japan of manipulating its exchange rate. From 1985 to 1994, the yen appreciated from Y265 to Y85, without achieving a significant change in the trade imbalance. Yet, Treasury Secretary Lloyd Bentsen was actively talking the dollar down, even as Japan was mired in a recession that contributed to deflation. In my view, the U.S. stance then was misguided and exacerbated the problems Japan faced after its bubble burst.

During the past decade, it appeared we might be headed for a similar conflict with China, as its current account surplus mushroomed after it had been granted status in the WTO.  Faced with protectionist pressures in Congress, the Chinese authorities pursued a policy of allowing the yuan to appreciate steadily versus the dollar (by 35% over the past 10 years), while also accumulating massive FX reserves, most of which consisted of U.S. treasuries.  Read the rest of this entry »

Emerging Market Equities: Separating the Wheat from the Chaff

November 30th, 2015


  • Since 2011 emerging market (EM) equities have lagged U.S. equites considerably, and the valuation for the MSCI Emerging Markets index has fallen to a record low recently. While this could signal a buying opportunity, our view is an underweighting of the asset class is warranted amid a significant slowing in credit growth and uncertainty about how EMs will fare when the Fed tightens policy. 
  • Nonetheless, this is a good time to formulate a strategy for investing once conditions stabilize. Because there is likely to be considerable variation in the performance of individual markets in the future, careful country selection will be critical to success.
  • The challenges are formidable, because the nature of emerging market crises has evolved and countries confront a myriad of problems with differing policy choices. For example, the build-up in debt since the Global Financial Crisis has been greatest in China and other Asian economies, but they also have leeway to ease monetary policies because inflation is low. By comparison, countries such as Brazil, Russia, and Turkey have less latitude to ease policies with inflation high.
  • An ongoing challenge is to assess whether expectations that are priced into markets will be met, which is not easy. A noteworthy example: The BRICs concept became popular when China’s emergence contributed to a commodity boom, but it has lost relevance today as expectations proved to be unrealistic.

EM Equity Underperformance: Secular Forces

Over the past year, investors have increasingly become concerned about the ongoing slowdown of China’s economy and the spill-over it has had on other emerging economies. The combination of plummeting commodity prices and currencies and deteriorating corporate profits resulted in emerging market equities posting an overall decline of 9.4% through the end of October. At the end of September, when returns were minus 15%, equity valuations based on the MSCI index had fallen to a record low of 12.8 times 10-year average earnings, or roughly one half the long-term average. Click to see more.

Impact of Global Economic Conditions on Cross-Border Mergers and Acquisitions

October 30th, 2015

Remarks delivered at ACG Cincinnati’s Forum on October 28, 2015

The bottom line: While recent market volatility has clouded the outlook for global M&A activity, it is unlikely to reverse the trend barring a recession, which we do not expect to materialize any time soon.


  • In recent years, M&A activity has been relatively strong in developed economies but softer in emerging economies.
  • During the 12 months ended in March of this year, total deal value globally increased by 38% to surpass $2.1 trillion with blockbuster deals in healthcare, telecom, and technology leading the way.
  • At the start of this year, dealmakers were optimistic that economic conditions would support further rapid growth of cross-border M&A. In a survey conducted by KPMG and Mergers & Acquisitions magazine, the most important factors they cited were (i) large cash reserves and commitments (40% of respondents), (ii) opportunities in emerging markets (19%), (iii) availability of credit on favorable terms (16%); (iv) improved consumer confidence (13%), and (v) improving equity markets (8%).
  • However, conditions turned less favorable in midyear when markets became more volatile and risk assets sold off. Additionally, credit spreads widened, especially for high yield bonds, and world trade slumped, while commodity prices plummeted. The catalyst for these conditions was weakness abroad, especially in China and the emerging market economies.
  • Investors are now well aware China’s economy has slowed considerably, but the magnitude is unclear. Policymakers have mishandled the country’s stock market and exchange rate policy. The principal risk would be a bust in the property market that impacted financial institutions. While the government would infuse capital into the system, as needed, China could experience a growth recession.
  • The softening in China has impacted emerging market economies and weakened commodity prices and import demand. Countries feeling the fallout include commodity exporters and those exporting goods to China. Several countries are in recession – notably Brazil, Russia, and Venezuela – due to internal mismanagement.
  • According to the IMF’s World Economic Outlook in October, real GDP growth worldwide is projected to slow to 3.1% this year – the slowest since the 2008-09 Financial Crisis and a half of a percentage point below the IMF’s forecast at the beginning of this year. While the IMF expects growth to rebound next year, past forecasts have proved to be too optimistic.
    World Economic Outlook
  • A key factor that could affect U.S. multinationals is the strong dollar, which will encourage them to base more production offshore.
  • The interest rate environment should remain benign, as policy tightening by the Federal Reserve is likely to be very gradual in 2016, amid low inflation and considerable uncertainty about the global economy.
  • LBO activity could be affected by the widening in credit spreads for below-investment grade borrowers. Thus far, however, it appears to be manageable.

Assessing China Risks

September 23rd, 2015


  • Risk assets have sold off this quarter amid concerns about weakness in China and other emerging markets (EM). While our base case scenario calls for a gradual slowing of China’s economy to 5%-6% in the years ahead, we consider two alternative views that are decidedly less favorable.
  • One view is presented in a report by Citi Research, which concludes China’s growth is likely to slow to 2% next year, which would drag the global economy into a growth recession.[1] The other is an analysis by emeritus Professor Robert Z. Aliber, who contends a bubble in China’s property sector could have even greater adverse consequences for China and commodity exporters.[2]
  • While investors have been fixated on China’s stock market as of late, the performance of the property sector and financial system holds the key to whether China’s slowdown is gradual or abrupt. Unfortunately, lack of transparency makes it difficult to assign probabilities to various scenarios. However, the most likely outcome is the U.S. economy will not succumb to weakness abroad.

Assessing China Risks

Among the challenges investors face in assessing China’s prospects are a wide range of views about the economy and financial system. Many observers discount the official statistics that show the economy growing by 7%, considering that “hard data” such as manufacturing activity, electrical generation, and exports suggest much weaker growth. Capital Economics, for example, estimates growth is between 5%-6%, while Citi’s economists believe the likely number is 4% or less. The counter-argument by China optimists is that the economy is transitioning towards services, which is faring much better than manufacturing. Read the rest of this entry »

Global Growth Scare: What’s Real versus Imagined

August 24th, 2015


  • Risk assets have sold off considerably amid concerns about China and emerging markets (EM) in the wake of plummeting prices for oil and EM currencies. The catalysts were actions by China’s government to prop up the domestic stock market and to liberalize the country’s exchange rate policy.
  • While China’s economy is a “black box” for most investors, evidence of a slowdown in emerging economies is compelling: Growth in Q2 was the weakest since the Global Financial Crisis.
  • Thus far, the U.S. economy has performed very well despite the slowdown abroad, although market participants are nervous about the spill-over to the U.S.
  • Our own view is the U.S. economy is on solid footing; accordingly, we are overweight credit risk in fixed income portfolios. However, we are positioning equity portfolios defensively, as the stock market succumbs to its first correction in more than four years.

Background: Worries about China Spread to Emerging Markets

In two previous commentaries, I discussed concerns market participants had about China’s economy in the wake of government actions to prop up the domestic stock market and to alter the country’s exchange rate policy.[1] My conclusions were that the stock market actions were misguided; however, the decision to allow greater exchange rate flexibility was sensible and consistent with long-standing objectives to make the exchange rate more market-determined. Nonetheless, while I continue to hold these views, there is no denying the change in exchange rate policy was widely interpreted as a conscious effort to devalue the RMB, which, in turn, contributed to pressures on EM currencies, as well as oil prices.  Read the rest of this entry »

China’s Exchange Rate Policy: Separating News from Noise

August 12th, 2015


  • Global markets have reacted strongly to China’s announcement that it will let market forces play a greater role in determining the value of the yuan. News reports have portrayed the action as a devaluation that could lead to a bout of “currency wars.” Such reporting in my opinion is pure noise.
  • The more important issue is how much China’s economy is slowing. Our base case is the economy is on a controlled glide from 7% to 5% growth, which is largely priced into markets. However, China’s economy could turn out weaker, which would send ripples across global markets, especially emerging economies.
  • Meanwhile, we are maintaining our investment strategy of over-weighting credit risk in fixed income and higher-quality names in equities.

Implications of China’s New Exchange Rate Policy

The Bank of China surprised market participants yesterday by announcing that it would allow market forces to play a bigger role in determining the value of the yuan. Previously, the central bank set the value of the yuan against the dollar and allowed it to fluctuate in a narrow range around a central parity. Going forward, the authorities will set a reference rate for the yuan based on the market’s previous close and they will allow the currency to trade in a 2% band around the rate. When the yuan depreciated by 1.6% on the first day of trading, newspaper accounts declared that it was the largest devaluation of the yuan in more than two decades and that it threatened to set off a “currency war” if the yuan continued to slide. The lead story for the Financial Times, for example, carried the headline “China Risks Clash with US”, while the Wall Street Journal’s read “Strains Mount After Chinese Devalue Yuan.”  Read the rest of this entry »