Recent events overseas have conspired to cause investor skittishness and a stock market selloff in the U.S. In our view, while the level of uncertainty has risen, there is no reason to panic and exit stocks. We believe the U.S. economy will continue to trudge along at its recent 2-2.5% rate of growth, and we see it as relatively well insulated from external forces, with only about 13% of our economy driven by exports. Interest rates, inflation, and unemployment are all at low levels, and if the Fed does raise interest rates this year it is likely to be at a measured pace.
In the classic film The Wizard of Oz, Dorothy and her friends seek out the Wizard in the Emerald City, and, after a long journey, arrive only to discover that he is just a normal man hiding behind a curtain, pulling levers and pushing buttons to create wizard-like special effects. We think this analogy fits China today, where a centrally planned economy grew at double-digits for most of the past decade but is now slowing markedly. While Chinese officials have targeted 7% growth for 2015 and have held steadfast to that goal, we believe statistics coming out of China this year suggest a much slower rate of growth. This matters because China has been a key engine of growth for the global economy, and, if that engine is indeed sputtering, then global growth forecasts may need to be revised lower.
Investors have many reasons to be skeptical that China is continuing to grow at the 7% rate that its government reports. During most of 2014 electricity consumption grew at 5%, while so far this year consumption growth is closer to 1%. Exports have been in decline for most of the year, with July down 8% from a year ago. Industrial production, which averaged 9-10% growth in 2012-2013, has decelerated steadily since, and so far in 2015 has averaged just 6%. Commercial and residential building starts have both declined at a mid-teens rate so far this year. And, in our view, the steep price declines this year across the commodity complex cannot be explained without incorporating a slowdown in demand from China, the world’s largest consumer of many basic materials like copper and iron ore.
As the Chinese leadership marshals its capabilities to drive growth, yet still may be falling short, investors may be starting to lose confidence in Beijing’s stewardship of its economy. We believe the clearest example of this was the heavy-handed manipulation of its equity markets this summer, which put the man behind the curtain front and center in headlines across the world. It was with this backdrop that the People’s Bank of China surprised the capital markets on August 10th by changing its policy and allowing the yuan to depreciate, and pledging to incorporate market-based measures into its exchange rate determinations going forward.
We believe the yuan devaluation may serve many purposes at once. We think it can be a tool to drive growth because it provides a relative advantage to China’s exporters. We also think it might help China to fight deflationary pressures by making imports more expensive to Chinese consumers and by absorbing some excess production capacity. It is a step toward a true free-floating currency, which furthers the nation’s strategic goals of establishing a yuan-based trade bloc in Asia and ultimately joining the elite group of reserve currencies held en masse by central banks globally. However, it could also prove to be an historic shot in the currency war that has engulfed the post-financial crisis world, especially if competitive Asian exporters like Japan and Korea respond in kind. If currency weakness were to spread across emerging markets, then nations with significant dollar-denominated debts become vulnerable to capital flight or even sovereign default. While we are not forecasting a repeat of the 1997 Asian financial crisis that followed the Thai baht devaluation, a similar series of events is a potential unintended consequence of China’s action.
It is our belief that global equity markets have declined since August 10th because of the heightened level of uncertainty resulting from the yuan devaluation. In our view, the current situation is somewhat different from other recent geopolitical crises (Greece, the U.S. debt downgrade and threatened government shutdown) in that there is no one obvious action that would resolve investor anxiety and drive a relief rally. Nevertheless, in the U.S., where the domestic consumer matters much more than exports, the China slowdown and devaluation should not have a significant impact—certainly not enough to trigger a recession. Indeed, we expect U.S. economic growth this year to continue at about the same pace that it has averaged since the financial crisis.
As a precautionary measure, over the past ten days we have repositioned most client equity portfolios more defensively, but in our view the case for a more meaningful pullback in equities than has already occurred is not well supported. If anything, the disinflationary forces which may emanate from China as a result of its slower growth could lead the Federal Reserve to delay its plans to hike short-term interest rates, which might alleviate some investor concerns and support U.S. equities. Furthermore, the declines in commodity prices over the past year from crude oil to rubber to copper should provide a benefit to manufacturers who utilize those raw materials over the coming year, and some of those benefits will likely be passed along to consumers in the form of lower prices. As always, we will continue to evaluate the situation as it unfolds, and will seek to provide downside protection for clients when needed in order to produce positive long-term results.
This information is intended solely to report on investment strategies and opportunities identified by Roosevelt. Opinions and estimates offered constitute our judgment and are subject to change without notice, as are statements of financial market trends, which are based on current market conditions. This material is not intended as an offer or solicitation to buy, hold or sell any financial instrument. References to specific securities and their issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Please contact us at 646-452-6700 if there is any change in your financial situation, needs, goals or objectives, or if you wish to initiate any restrictions on the management of the account or modify existing restrictions, or if you would like to request a copy of our Code of Ethics. Our current disclosure statement is set forth on our Form ADV Part II, available for your review upon request, and on our website, www.rooseveltinvestments.com.