Crouching Tiger, Hidden Drag On Emerging Markets

Brian Selzer

OCEAN CITY — Chinese policymakers jolted the markets last week with a series of devaluations of the yuan. The move came in response to building stress around a currency that had remained remarkably strong despite China’s slowing economic growth and continuing capital outflows. The reaction to the move echoed across all regions and asset classes, reflecting China’s dominant influence on the global economy.

While the direct impacts of the policy shift will likely be limited to Emerging Markets, particularly in Asia, the uncertainty around the implications for global growth and currencies may bring higher volatility for the markets. We favor developed markets within equities, and advise being selective in Emerging Markets with a preference for reform-minded countries such as India.

The primary driver of the yuan devaluation was to support Chinese economic growth by boosting export competitiveness and supporting local products over imported ones. The devaluation followed a month in which Chinese exports had fallen more than 8% on an annualized basis and concerns of slowing activity had intensified. Since the global financial crisis, many countries have used currency devaluation as a tool to boost growth. However, given that a weakening yuan effectively strengthens the currencies of other nations, those that either export heavily to China or compete directly with Chinese exports will likely suffer as a result. This has sparked concerns of a series of competitive devaluations, raising the potential for beggar-thy-neighbor trade policies which would ultimately weigh on global growth.

Last week, countries highly dependent on China for trade engineered similar drops in their currencies. Vietnam widened its currency’s trading band to allow it to weaken further, reaching an all-time low against the U.S. dollar. Taiwan lowered its overnight deposit rate for

four days in a row, bringing its currency to the weakest level in nearly six years. Commodity-producing countries in Africa and Latin America saw their currencies fall as well, as investors anticipated a drop in demand for their exports.

China is the largest consumer of commodities, and given that most are priced in U.S. dollars, a weaker yuan will likely reduce demand and weigh on prices, at least initially. This bodes poorly for commodity-producing countries, mostly in the Emerging Markets. On the other hand, it will be a boon for net importers of natural resources, such as the U.S., Europe and Japan.

Additionally, the drop in the yuan reduces Chinese demand for imports, which come mostly from Asia. However, while both Japan and Europe export heavily to China, they import even more.

The BofA Merrill Lynch (BofAML) Global Research Economics Team estimates the impact of the devaluation to be minimal for both countries, although the second-order effects may weigh on economic growth, particularly if the yuan weakens further.

The U.S. is relatively more insulated on a trade basis, but a stronger dollar may pressure growth, and weaker commodity prices will keep inflation muted in the near term. As a result, speculation has risen that the Federal Reserve (Fed) may delay its first rate hike. Investors responded by rushing back into fixed income, causing yields to drop. We still believe that “liftoff” will happen in September, but acknowledge that the risk to global growth from China could slow the pace of subsequent hikes. We maintain our view that rates will rise,

but slowly and gradually.

(A Merrill Lynch Wealth Management Advisor who can be reached at 410-213-8520.)

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