Over the weekend, China announced its intention to de-peg the value of its currency from the U.S. dollar. While details are sketchy, the statement from the People’s Bank of China referred to the value of a ‘basket of currencies’ in managing the exchange rate of the Yuan.
In effect, the announcement takes us back to the managed exchange rate system that prevailed in the 2005-2008 period. During that time period, the exchange rate was managed relative to an undisclosed basket of currencies. However, the currency did appreciate some 20% or so against the U.S. dollar during that three-year period, before the dollar peg was reintroduced at the onset of the global financial crisis in 2008.
We have been regularly discussing the outlook for China’s growth, most recently last week: Sizing Up China’s Growth Prospects. We have been concerned about the downside risks to China’s growth prospects given its active efforts to confront its property bubble.
In today’s write up, we try to interpret this move by the Chinese authorities within the larger framework of assessing the Chinese growth outlook.
Coming as it did just days prior to the G-20 meeting in Toronto, the timing of the decision could hardly be called a coincidence. This move has effectively removed China from the hot seat in this conference by addressing this major source of friction with its trading partners. Skepticism aside, the decision is a net positive at a number of levels.
Protectionism Threat Averted, For Now
The U.S. and world economies would be net gainers if this decision can remove the threat of trade protectionist measures being enacted in the U.S. Given the continued tough labor market environment here, which is not expected to materially improve for a while, the chances of some sort of punitive measures being enacted could not be entirely ruled out. This is particularly so given the heated political backdrop of a mid-term election year.
On the other hand, the exchange rate may not move significantly enough or fast enough. So the extent and pace of the Yuan revaluation may not be enough to fully satisfy China’s detractors. As such, the threat of a trade war with China may be only temporarily removed.
The politics of the issue aside, even a significant revaluation of the Yuan exchange rate may do little to bring back manufacturing jobs to the U.S. or lower its trade deficit. In an integrated globalized world, manufacturing activities will continue to gravitate to the more cost efficient locations. If production costs increase in China as a result of its exchange rate scheme, some of its more cost-sensitive manufacturing activities will move on to even cheaper international markets instead of the U.S. or Western Europe. A complete reversal in the U.S.’s trade deficit also remains unlikely as was seen in the 2005-2008 period when an equivalent exchange rate regime was in effect.
Confidence in China’s Growth Prospects
The move is clearly a signal by the Chinese authorities of greater confidence in their growth outlook. While sudden moves on the Yuan revaluation front are not expected, even modest but steady moves in that direction will promote domestic consumption, while de-emphasizing the significance of lower-priced exports. Given the potentially increased purchasing power of the Chinese consumers, the move has the potential of giving support to the global economy.
The Yuan revaluation, even at a modest pace, limits the inflationary risks that had steadily been building up in the Chinese economy. Recent trends in consumer prices had been indicative of such a build up, which had been stoking fears of an overheating economy. We were expecting tightening moves by the Chinese monetary authorities in response to the property bubble and emerging pricing pressures. The need for such monetary tightening is no longer as urgent as prior to this move.
Investment Implications
Prior to this decision by the Chinese authorities, I was growing wary of China’s growth prospects and was looking for reduced exposure there, at least in the near term. While I continue to see downside risks in the Chinese property/real estate sectors and will continue to stay away from them, the outlook for sectors and industries dependent on Chinese demand has favorably shifted after this move. Commodity and basic materials industries, particularly those denominated in dollars, should benefit from the enhanced Chinese purchasing power.
Negatively affected would be companies that source relatively low-margin products from China, primarily due to the country’s cost advantage. Manufacturers of lower end textile and furniture products may find their competitive edge eroded in this environment. Also affected would be discount retailers, such Wal-Mart, that source significantly from China.
Portfolio Update
We added three stocks last week, two to the Focus List and one to the Growth & Income portfolio. There were also changes to the Timely Buys list.
We added Chipotle Mexican Grill (CMG), the $4.3 billion market-cap fast-food restaurant operator focused on serving a menu of burritos, tacos, burrito bowls and fresh salads from about 1,000 restaurants. This company offers a very health mix of growth visibility, operating stability and a U.S. centric business model that we favor in the current environment.
We also added the $25 billion market cap farm equipment leader, Deere & Company (DE), to gain leverage to its impressive earnings momentum. The company is seeing robust demand for its products in key emerging markets, such as Brazil and Argentina, as well as in developed economies, such as the U.S. and Canada.
We added PetSmart (PETM) to the Growth & Income portfolio to gain exposure to a relatively stable and domestic-oriented retailer. This specialty retailer pays a healthy dividend, currently yielding 1.3%, and recently reported better-than-expected first quarter results.
