It’s not what you said, it’s how you said it…from China to CGOs

Takeaways: Last week’s engineered fall in the Renminbi was actually pretty modest, certainly in the context of the currency’s recent appreciation. More significant is what the move signalled – or more pertinently the market interpretation of those signals in the context of the un-virtuous circle of weak Chinese demand,  falling commodities prices, a stronger dollar and increasingly stressed ‘emerging markets’. It’s a fragile situation that shouldn’t stall markets, but will make them more discerning as we move into pivotal month.

Vicious circles

On Tuesday 11 August, the People’s Bank of China (PBoC) cut the Renminbi-dollar reference rate by 1.9% – the largest daily change on record – which contributed towards a fall of around 3% in the RMB across the week as a whole. The PBoC also established a new pricing regime. The bank will still set the reference rate, which has a 2% each-way limit for onshore trades; but in setting this rate, the PBoC will take closer consideration of moves in the unlimited ‘offshore rate’. 

The move has fuelled speculation that China is abandoning its attempt to rebalance its economy towards consumption-led expansion and away from export-led growth. However, China said at the weekend that it’s not seeking to depreciate its currency significantly from this point. If we take this statement at face value, China hasn’t done enough to the RMB to achieve any export related goal and it’s a pretty weak opening salvo in any supposed currency war.  If you take into account recent appreciation, it’s a modest move that just lets a bit of air out of the tyres and lines the RMB up to join the IMF’s club of elite currencies, perhaps in late 2016.

 So is this much ado about nothing? Not exactly. Whatever the PBoC’s motives – and they are unlikely to be simple – the move has created some uncertainty about the path of the RMB and focused attention on China’s struggle to manage its markets and economy, at least with the same control as it has in the past. Hardly news, but timing and context is everything. The RMB has moved by this much in a week before without a market murmur; but this was without a change in protocol. And a good part of this market furore is linked to the co-incidence of data and sentiment that’s feeding into an accelerating vicious circle encompassing China, commodities, the dollar and other emerging markets.

We start with China’s stock market turbulence, combined with weaker economic data, which  has raised questions about the strength of its levers. A Moody’s report out this week forecasts growth of 6.8% in 2015 and 6.5% in 2016. This comes in the context of weak global growth, expected at just 2.7% for the G20 this year. Against this backdrop, commodity markets look increasingly oversupplied, with a stronger dollar pushing further down on prices.  Anticipation of an imminent rise in US interest rates – along with falling commodity prices and Chinese demand – is bearing down on exposed emerging markets. Outflows in the last 13 months have been double than during the financial crisis.  As currencies fall against the US dollar, this lowers demand for imports, dragging down aggregate demand, raising deflationary fears… and round we go again.  How fast and how far depends on a whole wealth of known and unknown unknowns – not least the Fed’s and China’s next moves and how this feeds into market sentiment.

As HSBC economist Stephen King notes in the FT, China has been the world’s consumer of last resort through the financial crisis and recovery, a role previously played by the US. China’s efforts to rebalance has diminished its role as the world’s shock absorber. Other ‘emerging markets’ aren’t going to be the growth engine either. Overall emerging market imports are 13.2% lower year-on-year, according a moving average compiled by Capital Economics. The Eurozone might – as the S&P notes – look like a credit safe haven in the global context, but 1.5% growth isn’t much of an engine. The US? Not with an impending interest rate rise. Although, next to no inflation and international doubts might just tip the balance away from a move – again. The July minutes read pretty dovishly, expressing plenty of concern. Will there ever be a good time?

Concerns are mounting over rising defaults in China, which in turn are raising the thorny problem of moral hazard. The FT reports that eleven shadow banks have written an open letter to the top Communist party official in northern China’s Hebei province, asking for a bailout that would enable the bankrupt company to backstop loans. If the guarantor cannot pay, the FT reports that it could led to defaults on at least 24 high-yielding wealth management products (WMPs).

There is also the potential for China’s outbound investment to accelerate, in a similar way to pre-crash Japan, if investors fear further devaluation  and rising trade barriers  – and if investment opportunities in China are limited.

Taking the temperature

We say ‘emerging markets’ but term looks ever more obsolete as fates diverge under these stresses.  Brazil is in recession, whilst India expects growth of around 5% this year. Oxford Economics has modelled the impact of a 10% Chinese devaluation and a sharp slowdown, picking Brazil, Russia, Chile and Korea as the most exposed. The Turkish lira, Russian rouble, Chilean peso have all hit the headlines this week.  It remains to be seen if investors will differentiate, but there are opportunities for those who can discriminate. This won’t be limited to ‘emerging nations’. In 2015, GDP growth is forecast at around 4% in Ireland, 3% in Spain and 1% in France – the power of structural reform….

We expect to see more discrimination across markets as and when capital conditions change. There are signs of this now, as Jim Croft at Standard Bank notes (as quoted on FT Alphaville):

“Currently the market in liquidity not actually that bad, but rather is bifurcated. In the old world, liquidity was overly abundant and banks would offer it to anyone. Now liquidity is more expensive it gets shown more selectively and is targeted to people perceived to be most likely to pay for it. This is why those that have adapted to the new pricing still think liquidity is reasonable, while others don’t.”

The means and imperative for companies to do deals and raise debt will likely remain;  but for some there is and will be a significant increase in price.  The rush to get deals done this summer, despite the lure of the beach, could be as much about macro concerns as the Fed. In 2015, slow growth has encouraged deals. However, as we’ve said before, at some point markets that have provided the fuel for this M&A boom will begin to show the strain if growth prospects don’t begin to improve. There is only so much companies can do to boost their earnings outside of revenue growth.

The latest US earnings season was better than the weak expectations, but they were flat year-on-year and revenue fell by 3.5%. UK earnings expectations have improved, but remain in negative territory. Interesting to note then, the latest appointment of  ‘chief growth officer’ at ConAgra.  CGOs have been around for a while and it’s an trend that we noted in our latest Corporate Development Officer Study. As pressure to increase revenue in a low growth environment increases – and activists increase their focus on improving operational performance – we could see more high profile appointments.