Summary: The trading paradigm has shifted in China – a weakening and more flexible RMB relieves pricing rigidity, and transfers the costs of economic restructuring externally. The PBoC’s tolerance of RMB depreciation will influence how Chinese markets react post Fed hike - watch the RMB reference rate. For risk assets, the Fed’s balance sheet size matters more than interest rate. It has plateaued, and so has US earnings growth. Despite strong technical reprieve, US stocks have not scaled new highs for some time.
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A trading paradigm shift; the PBoC’s tolerance of RMB depreciation is key; watch RMB reference rate: On December 18 2013, the Fed announced its much-anticipated decision to taper on its asset purchase program. Global markets rejoiced, except China and Hong Kong. On the following day, these two on/off-shore Chinese markets opened high, but ended significantly lower – despite strong rallies in other Asian markets. Why?
On the morning following the Fed’s decision, the PBoC surprisingly lowered the RMB reference rate by the most since May 2013. It was only guided lower by 0.13% - a soft depreciation compared with the RMB volatility these days. Stocks’ weakness ensued. Back then, a depreciating RMB was considered a strong deflationary element on the global economy, as well as a potential trigger on currency war. As the RMB weakened, China’s buying power on commodities waned, and pressured on the prices of risk assets. We believe the PBoC’s decision to lower the RMB reference rate that led to the under-performance of both A/H shares that day. But it was all about to change in mid March 2014.
In the second weekend of March 2014, the PBoC suddenly announced that it would expand the RMB daily trading band from 1% to 2%. Following the aforementioned logic, the market considered this announcement an act of depreciation and thus a menace to the global economy. Volatility started to spill over from the currency market to equities. Such logic continued to pressure on the market for the subsequent months – till mid 2014 the market came to terms with the benefits of RMB depreciation. Stock market trend started to diverge from exchange rate – and a trading paradigm emerged (Focus Chart 1).
Focus Chart 1: A trading paradigm shift – a weakening RMB supports stocks.
In general, under a rigid exchange rate system, such as the one in China before the currency reform, the PBoC should adjust its reference rate to reflect the changes in the economy. When the PBoC resisted exchange rate adjustments when fundamentals weakened, relative price adjustment must manifest itself through commodities and asset prices. China’s resistance to currency depreciation after the Asia Crisis was one of the reasons why the Chinese stock market fell more than 10% in 1998.
As the Chinese Yuan had indeed appreciated in slowing economy in the past few years, such rigidity has shown through PPI deflation and a waning stock market – until the exchange rate reform started in March 2014. This theory of relative price adjustment can also explain why Hong Kong underperforms the mainland since mid 2014. The pegging of HKD to USD has made Hong Kong’s exchange rate too rigid to reflect weakening fundamentals. Thus depreciation has shown through asset prices.
While the further currency reform in August this year induced a significant market correction, but it has resulted in a more flexible exchange rate regime that makes China better cope with external uncertainties. Although the risk of capital outflow and potential spillover from exchange rate volatility remain, investors should not focus excessively on short-term market fluctuations.
Focus on the Fed’s balance sheet size, not on Fed fund rate level: Market participants’ eyes are fixated squarely on the Fed’s decision on interest rate. After all, this will be the first rate hike since almost a decade ago. But note that the US stocks have largely plateaued since around March this year. Concurrently, we observe that the Fed’s balance sheet expansion, which began in late 2008, has halted. And the S&P 500 companies’ EPS has stopped to grow, too (Focus Chart 2).
These phenomena are not coincidences. The Feds asset purchase to expand its balance sheet size supports risk assets. If earnings fail to grow, as it have been recently, interest rate increases will suppress valuation multiples. And markets will hit the wall, and will even induce systematic risks.
Focus Chart 2: Fed’s balance sheet size and earnings growth matter more than interest rate.
Hao Hong, CFA
2015-12-17
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