On August 11, the day Beijing shocked the world by devaluing the yuan, a whole host of commentators suggested that the move was designed to bolster China’s bid for SDR inclusion.
To be sure, the timing would have been right. On at least two separate occasions in August the wires lit up with reports that the IMF was leaning towards making the RMB the fifth currency in the basket and with the official decision due in November, some believed China was simply trying to seal the deal by making it seem as though the market would play a greater role in determining the exchange rate going forward.
Of course that’s all nonsense. First, the market doesn’t play a greater role in the new FX regime. In fact, the market’s role is reduced. Previously, the PBoC manipulated the fix to control the spot, but now, the central bank manipulates the spot to control the fix and manipulating the spot means heavy-handed intervention.
Second, China’s deval has far more to do with a desperate attempt to boost the flagging export-driven economy.
Sure, the official headline GDP print can be whatever a bunch of Politburo central planners want it to be, but the reality (as measured by the Li Keqiang Index and by private economists outside of the bulge bracket) is that growth is nowhere near 7% and indeed, it might very well be that in times of rapidly declining commodity prices, China’s inability to accurately measure the deflator means real output would be materially overstated even if the NBS were putting out accurate figures otherwise.
The point here is that China’s hard landing has just begun and the 3% August deval was just the opening salvo in what will likely be a far larger effort to drive the yuan lower (remember, when Beijing burns through its reserves to support the yuan and close the onshore/offshore gap it doesn’t mean that China has changed its mind on devaluation - it simply means the deval will be conducted on the PBoC’s terms, not the market’s) and thereby boost the export-led economy. The country’s acute overcapacity problem combined with lackluster global demand and depressed trade (in relation to which China is both the proximate cause and a victim) mean that things are likely to get far worse before they get better and we’re starting to see the ripple effects in the country’s onshore bond market where defaults are becoming increasingly common as the country approaches its dreaded Minsky Moment.
So if we assume that China’s hard landing can and will get hard-er-er, it’s worth asking which assets and currencies have priced in a further deceleration in the world’s engine of global growth and trade. Here’s Barclays with more on what’s expensive and what’s cheap vis-a-vis persistent deterioration in the Chinese growth story.
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The underperformance of China-sensitive assets raises the question of whether they are already pricing in weaker activity. We compare asset performance over the last year to that implied by slower China growth and the controls; these residuals help us assess whether China-linked assets are reflecting the weaker growth backdrop. We complement this analysis with various valuation frameworks that help us gauge what may be priced into assets, given the risks to Chinese growth. Our analysis shows that EM equities and some commodity price residuals are currently very positive, suggesting the slowing in Chinese activity over the past year is not fully priced (Figure 4). Within equities, EM countries are most expensive relative to the Chinese cycle. The residuals for some of the usual beneficiaries of China’s growth, such as LatAm, Korea and Chinese equities, are very positive, suggesting the bounce in these assets following the August sell-off was overdone. In FX, the most interesting finding is that most Chinasensitive currencies appear cheap, especially commodity currencies and high beta EM. Notably cheap currencies are those of oil producers (the RUB, MYR and COP). The BRL and TRY are examples of currencies that are weak due to domestic issues. The high-beta IDR bounced back strongly at the beginning of Q4 and now looks expensive. The INR also has a positive residual because of idiosyncratic factors. In commodities, Brent looks cheap to the China cycle, while gold and copper are expensive.
In fixed income markets (Figure 5), US yields are higher and Europe and Japan yields are lower than what Chinese activity, US 2y yields and the VIX would predict. The negative deviation in Europe suggests that ECB easing expectations are the main reason for the gap. Similarly, Japanese yields are also lower than predicted, but to a lesser extent. US 5y yields are higher than predicted, as the Fed is set to hike as other central banks are still easing. While US nominal rates are higher than predicted, inflation expectations are lower, suggesting US real yields are relatively attractive. In credit markets, corporate spreads are in line with predicted, though elevated HY spreads reflect oil exposure. EM corporate and sovereign spreads are in line with our model results. Residuals for US IG spreads are also close to zero. On the other hand, US HY spreads are much higher relative to the model predictions, likely reflecting oil and commodity exposure. Finally, US MBS spreads are slightly tighter than predicted.
We analyze the sensitivities for over 100 assets and present a summary of our findings in Figure 6. Many China-sensitive assets are vulnerable to renewed losses, as they have performed better than our model predictions. These include copper, gold, EM equities (local terms), IDR and EM corporate credit. Such assets are not necessarily cheap, either, and in some cases are still expensive based on various valuation measures. Real copper and gold prices are still well above pre-super cycle averages, and many China-sensitive currencies are still over- or fairly valued (CNY, AUD, NZD, SGD, RUB, etc).
EM equity valuations are relatively cheap, but the headwind from slower China growth is notable and EM FX is still an overhang. EM corporate credit versus US IG relative spreads are back to average levels, suggesting China risks are not fully priced. However, a number of high yielding EM currencies have already been hard hit and valuations are already cheap for idiosyncratic reasons (BRL, MYR, COP, ZAR). DM equities and credit are less sensitive to China, but we find that energy and materials credit spreads have risen by much more than earnings yields.