What to make of the surprise RMB announcement from the PBOC?

Immediately after the surprise announcement on August 11, the media started to interpret the move as either 1) the beginning of China's efforts to weaken the Renminbi (RMB) in order to stoke exports and further intensify the currency war or 2) as a step toward allowing market forces to play a larger role in determining the value of the RMB in a bid to ultimately gain reserve currency status. The market interpreted the event mostly as the former despite the PBOC wanting the world to believe it was the latter. It is our belief that the truth, as with most things in life, lies somewhere in the middle.

The interpretation that the Chinese are moving in the direction of a market-based valuation for their currency is credible. Beijing knows that a 3% depreciation in the RMB will not suddenly reverse weakening exports or significantly stimulate the economy. Exports have steadily been declining as a percentage of GDP for some time and devaluations can have dangerous side-effects that the Chinese leadership is well aware of, such as encouraging an exodus of capital which would further complicate Beijing's calculus in trying to reduce leverage in their economy.

Furthermore, the RMB has been too strong from a trade view and its peg to the US dollar is not ideal for an aspiring reserve currency. It is difficult to pinpoint how overvalued the RMB was but if one must place a figure on it, according to our models the Renminbi was overvalued by 5% to 10% ahead of the August 11 announcement.

For external observers the timing is suspicious and the opaque nature of China's statistics is leading investors to conclude that the PBOC's action is an acknowledgement that China's slowdown is worse than the official data suggests. But in considering the IMF's recent comments regarding the guidelines for RMB admission as a reserve currency, the timing of letting the market set the RMB exchange rate in fact makes sense. It is possible that the reform camp (particularly the PBOC chief) within China is re-exerting its policy direction by using the RMB as a means to push financial reforms further along.

While further RMB weakness is possible we believe it will be limited to no more than 10% in the six months after July and that there is a strong case of SDR inclusion followed by strengthening of the RMB.

Repercussions from the RMB Devaluation on the Currency War and the Exporting of Deflation

Interpreting the RMB move as the formal start of a currency war and a confirmation of a global deflationary trend has caused emerging markets to fall precipitously since August 11 and is now dragging down developed market equities as well. The Financial Media enjoys labels like 'currency war' and 'new normal' because they simplify complex market dynamics but the danger is that they tend to oversimplify and this can lead to incorrect conclusions.

If by 'currency war' one means the government is intentionally manipulating exchange rates to pursue their national economic interest, then the term quite accurately describes the current market environment following the BOJ's major announcement to weaken the Japanese yen and expand QE in April 2013. The ECB followed suit with its own monetary experiment which further weakened the euro. Active intervention in the currency markets has been a tradition by Asian exporting countries and many countries have followed this trend by weakening their own currencies. The BOJ and ECB no longer have flexibility in setting their short rates because of the zero lower bound environment, this leaves only QE and its effect on exchange rates as the last remaining tool.

This perception of an ongoing currency war was further reinforced when the Chinese government joined the fray with their August 11th announcement. The RMB was the only major currency that had retained its strength while the remaining global currencies weakened in sync against the mighty US dollar. When the last pillar of stability fell, market confidence broke down and the market concluded that we had formally entered a global currency war.

A key trend to watch, to gauge the particular type of currency war that is unfolding, is the rise of protectionism — symbolic of the dark days of the Great Depression. Today major free trade agreements, like TPP, are nearing completion; this currency war is of a different strain from the competitive devaluations of the 1930's. The understanding that currency wars don't always represent a great depression leads to the more relevant question: Are we entering a period of global deflation?

The Key Debate

The most debated question over the past few years is the deflation vs. reflation debate, the answer to this question is critical in determining the direction of the yield curve. Bond analysts have been wrong for the past two years because the world is more deflationary than the mean reverting models are accounting for.

The yield curve's persistent march lower is sending an unmistakable deflationary signal however this current deflationary environment is not the same as the one experienced during the Great Depression. The deflation of today is a more benign form typical of the period between 1870 and 1900. This view is explained in greater detail in 'Capitalising on the Pacific Decade: Taking the long-term view on China'.

The currency wars and the recent RMB devaluation are manifestations of the same long-term deflationary trend. Through currency devaluation, a country actually exports its domestic deflation to other parts of the world. The world is deflating not because of the massive destruction of aggregate demand witnessed during the Great Depression in the 1930's or Japan in recent decades, rather the world is deflating for more benign reasons:

  1. The world has excess productive capacity in many areas: oil from the shale revolution and the commodity boom, manufacturing, etc. A major culprit of this excess supply has been China's emergence as the world's largest manufacturer following its entrance into the WTO in 2001. As of 2012, China accounted for 22.4% of world manufacturing while the U.S. was second with a 17.4% share1. Much of this new manufacturing capacity did not exist prior to the new millennium, so China's industries have injected tremendous amounts of capacity, the only similar period in modern history is the rise of the United States as an industrial power in the late nineteenth century. Coincidentally, that period in U.S. economic history, called the Gilded Age (a term coined by Mark Twain) was also deflationary.
  2. China's rise as an industrial power, as well as the creation of a large consumer population with rising levels of wealth caused a distorted view of supply and demand. Commodity producers extrapolated from these years of ever rising demand and over-invested. As with all new paradigms before this one, they met the economic reality of diminishing returns and expectations crashed back down to earth. China's growth couldn't continue accelerating forever, and this realization is causing great pain for commodity producers. The normalization of Chinese growth (which many external observers interpret as a crash landing for the Chinese economy) is to be expected and is completely healthy. This adjustment of the demand and supply imbalance from the roaring growth of the last decade in China will likely take a few years, and will feel deflationary in nature.

The world only seems to be deflating, because we have grown accustomed to a very high growth period, caused by China undergoing a growth spurt in the last decade. When that growth spurt becomes the base (the numerator of yesterday's growth becomes today's denominator), then the perceived slowdown is merely a feeling of deceleration. But it is not a contraction and economies will continue to grow. It is not the kind of deflation caused by the destruction of demand like what caused the Great Depression.

Emerging Markets Slump: is the Downturn Structural or Cyclical?

The bear camp's position is well articulated by BCA Research, the argument posits that this downturn is structural, meaning it's much harder to reverse and will last longer2. The emerging market bull cycle was a fortuitous outcome of inheriting the positive effects from hard reforms following the 1998 crisis whereas the current leaders are less reform minded and more bent on populism. At the same time there was a debt-fueled consumption binge that aided growth in addition to investment booms in China that won't be repeated. This list needs to also mention the easy money games pursued by the central banks of the developed economies. The central message of the bears is that the 'Goldilocks Era' of the emerging markets is over and the downturn has just begun.

This logic is similar to the debate in 2013 during the early days of the Fed tapering talks. We believed at the time that emerging market debt assets were unattractive as the phenomenon of emerging market assets outperforming developed market assets was largely a monetary phenomenon. QE programs and a retail rush into EMD funds caused excessive borrowing by emerging market sovereigns and their corporate sectors. It was the easy money from the developed economies that fed into the bull markets occurring in the emerging economies.

Measured by equity market returns (in USD terms) since Bernanke first spoke about tapering, this bearish case against emerging markets has been proven correct. Since June 2013, the MSCI Emerging Markets Index has trailed the MSCI World Index by more than 30%. Our asset allocation team accurately underweighted emerging markets in favor of developed markets for the past two years and benefited from this weakness.

However the Asia ex-Japan component of the MSCI Index outperformed the overall emerging market index by 11% over the same period. The large-scale extraction of natural resources which fed into China's rapid industrialization was an important driver for the emerging markets (as much as for resource producing developed economies like Canada and Australia). Interestingly the Asia ex-Japan component significantly outperformed Canadian and Australian equities in USD terms over this period as well.

SecurityTotal Return in USD terms (05/31/2013 - 08/21/2015)
MSCI World Index (MXWO)+18.63%
Asia ex-Japan component (MXASJ) of the MSCI Index-3.06%
Australia (AS51 Index)-8.22%
Canada (SPTSX Index)-10.52%
MSCI Emerging Markets Index (MXEF)-14.07

Source: Bloomberg

A significant portion of emerging Asia is in fact a major consumer of imported energy, commodities and natural resources from other emerging market countries - China is a prime example. The precipitous fall in commodity prices, particularly oil, has yet to be fully factored into the trade balances of China, Japan and other oil consuming nations in Asia.

Emerging Asia stands to benefit not only from declining commodity prices but it also has room to cut rates and unleash their own monetary defense mechanisms – if needed. The PBOC won't let the RMB get out of control so in time stability will return to the currency and further rate cuts by high interest rate countries such as India, which stands to benefits the most from an environment of price stability, will likely follow.

Another reason for separating emerging Asia from the rest of the emerging market index is that the region's commitment to reform is real. China is at the forefront of repositioning its outdated economic model with financial and state-owned enterprise reforms, all of which are necessary but painful. A rigorous understanding of geopolitics needs to be developed into the investment process if one desires to invest in the emerging markets.

Lastly, there is something fundamentally different in the emerging Asian economies that the developed markets lack; positive demographics and a rapidly growing middle class, the foundation of economic growth theory. These non-commodity exporting countries are shown to have higher human capital if you look at test data that reflects excellence in math and science. It is a raw proxy but there is a very large, untapped pool of human capital that still resides in the emerging markets, which ultimately is the most important driver of sustainable economic growth. Asia is best positioned to reform itself out of the current difficulties and outperform the rest of the so-called 'emerging markets'.

What Are the Implications for Today's Investors?

Explaining current events is useful, but extrapolating from the narrative an actionable investment idea is the reason why the asset management industry exists. But as experience in finance teaches us, having a good investment idea alone is insufficient; the right timing is just as important. The following investment ideas are long term implications (more than a one year time horizon).

Implication 1. The equilibrium interest rates of today are fundamentally lower because of the deflationary forces at work, which cannot be easily captured in mean reversion models. Despite the Fed's intention to hike, the long end of the yield curve likely has more downside than upside.

The factors that these models fail to capture are the supply driven deflationary forces mentioned above, the demographic trend unfolding globally, an ageing population that creates an income mindset rather than a capital gains mindset, and the glut of global savings. These reasons will influence the Fed's hiking schedule and frequency, as well as the equilibrium rate at which the yield settles at when the hiking window is over.

In our opinion buying high quality long duration bonds is still a timely investment despite the market consensus to the contrary.

Implication 2. Emerging markets is really an outdated term for describing the rest of the world, but many of the indices reflect this outdated mindset. Effectively returns can be dragged down because low growth regions are lumped into the definition of an 'emerging market'. Despite the fact that China is now the world's second-largest economy, its representation in global equity indices is almost negligible because of capital controls. China accounts for about 15% of world GDP but comprises only about 2% of global equity indices. One can have a high conviction that this percentage will grow higher over time as China's role in the global economy is not likely to diminish. Asian bonds too will likely increase in their global weighting relative to US and European bonds. The original reason for investing in emerging markets in a globally diversified portfolio still remains valid, but benchmark hugging an outdated index is not the best way to do it. The way forward for emerging market investing is to be benchmark agnostic and mindful of the need for downside protection and geopolitical risks.

Implication 3. In a world with decelerating growth, excess savings, and persistent price deflation, the best place to be is still in equities.

First, this deflation is of the type experienced in the 19th century and not similar to the Great Depression's destructive deflation. Equities did very well during the Gilded Age. Secondly, from a duration standpoint, strong dividend paying equities have a longer duration than bonds and generate relatively strong income. Thirdly, decelerating growth is still growth; one just has to be very good at identifying growth areas within a deflating pricing environment.

An area to be watched closely is the high tech arena, particularly where disruptive types of innovation are developed. Currently much of this growth is not captured by listed companies and the venture capital industry is exerting a growing influence on emerging Asia (Beijing in particular) — far beyond their Silicon Valley roots. This has important implications for active portfolio management particularly in Asia.

Time to Get Active

Index making companies measure the market beta and create a reference portfolio from the market composition such that the value of active management can be measured. Passive investing in the last decade has dominated the investment behavior of many institutions. While passive investing, following a market index such as the S&P 500 or MSCI World, has a place within a healthy institutional portfolio, if the majority of market players pursued index based investing then the efficient capital allocating role of the equity markets would cease to function properly. In a healthy economy capital is allocated based on economic fundamentals of the underlying businesses. If too much capital is passively invested in indices then companies outside of popular indices would be stifled from growing as the allocation of capital gets distorted.

The flip side of this logic is that companies outside of the index can actually present a great return potential because the companies within the index move in tandem (despite their individual earnings) and those outside of the index tend to be undervalued. This phenomenon is already taking place to a degree and active management can benefit from this.

Another downside of an overreliance on market indices lies in the fact that indices are, by definition, backward looking and often based on market capitalization. Thus, the bigger the company the more capital it gets. For bond indices, this creates perverse market behavior that incentivizes higher leverage, the more a company borrows the more important it becomes. For a market going through a rapid transformation of its economic model and industrial structure, such as China, a backward looking investment posture based on market indices can be dangerous. This describes fairly well how many institutional players invest in China because of the accessibility problems and the ease of buying an index. Indices for China are dominated by large state-owned enterprises because of their large capitalization.

Considering these implications we conclude that a concentrated, stock-picking approach is the best way to serve a long-term investor's goal of capital appreciation. Concentrated stock-picking works because stocks are increasingly influenced by the index following crowd and this brings down the dispersion of stock returns. Over diversification in a stock portfolio converges its returns to the market beta, which will give a lower return because of lower future global growth. Another reason favoring concentrated stock-picking is that winners from this overly competitive world (and industries) will be fewer and fewer, thus rewards go to the concentrated few who have a competitive edge to flourish in this super competitive global landscape.

1Source: United Nations and MAPI: https://www.mapi.net/china-has-dominant-share-world-manufacturing
2Source: "The Coming Bloodbath In Emerging Markets", BCA Research Special Report, August 2015.