20 January 2016

Western markets set to beat to the Chinese drum

Investors are gradually coming to understand what outflows from China and a potential renminbi devaluation might mean for Western markets.


Already we have seen Chinese capital flows interrupted into such international property markets as London and Sydney. The pressure to devalue is contingent on the failure of Quantitative Easing (QE) to kick start Western economies. Instead it funded North American shale oil production which has deflated global oil prices and left precarious levels of debt in North America’s junk bond markets. It also saw the rise of investment opportunities into Emerging Markets, with debt levels in cheap US Dollars added sharply – Emerging Market (EM) foreign exchange intervention held their currencies down, driving QE’s stimulation effects. 

Basically now, we are seeing the after-effects; namely a bursting commodity bubble, devaluation pressures throughout Emerging Markets and the unravelling effects of investment patterns made by Sovereign Wealth Funds throughout that post-Crash period. I consider that the US Federal Reserve ought to have begun raising interest rates in 2012, when growth resurfaced again. Having not raised rates until December 2015, the US Federal Reserve now looks boxed in over its policy response, should the US economy stall from here. It may be that the recent rate rise has to be reversed and that further reflationary policies incurred by way of response. 

As things stand, a weakening outlook and further devaluation from China may only export further downwards pricing pressure; Western manufacturing output has already suffered as the lack of EM demand and increasingly competitive Chinese capacity feeds through. China has a command economy in which Communist party rule requires maximum employment levels to retain social order. With an overvalued exchange rate already squeezing their manufacturing base, finding a home market for all their output has become an imperative. 

Recent record spreads between the levels of the offshore versus onshore renminbi indicate huge selling pressure as the authorities try to stem domestic capital outflows. This is severely testing the depletion rate of Chinese foreign reserves. I see ongoing “baby step” devaluation pressures as persistent, with further deflationary pressures on Western markets. I would note that this capacity glut is already feeding into record lows for an over-supplied international shipping sector, with the Baltic Dry Freight Index suffering accordingly. 

Here in the UK, we have already seen these pressures with steel dumping closing domestic capacity at Redcar, Caparo Industries and now Tata Steel. Whilst the lowering effect on prices may boost Western consumers’ pockets in the interim, addressing indebtedness levels in China and other EMs will continue to see the pain of excess capacity being either fed into export markets or rationalised. On the latter point, we await concerted action from the Chinese authorities to boost their service sector output at the expense of outmoded manufacturing excesses, whilst concerted fiscal policies are already being enacted. 

I believe this dilemma will rumble on and affect Western stock markets throughout 2016.

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