It’s been an interesting market over the past few weeks. As we discussed in our 3rd Quarter Outlook, market movements in late June and early July were largely driven by concerns about the Greek economy. We stated then that while important to Greece and its major trading partners, the impact on U.S. stocks was largely overstated, and the focus would soon return to the key driver of U.S. stock values – U.S. corporate earnings. Until this past Tuesday, that was an apt description – the market in general increased in value when companies such as Google, JPMorgan, and Netflix reported good news, and declined when IBM, Apple, Exxon, and Viacom reported unfavorable results.
Then, on Tuesday, a surprise occurred – the People’s Bank of China (PBOC), which plays a similar role to the Federal Reserve Bank, announced that it was changing the way it pegged the Chinese yuan exchange rate to the dollar. Worldwide stock markets immediately reacted – the S&P 500 declined by 1%, and has been more volatile over the past couple of days. Below are some answers to questions that you might have about how that policy might impact your portfolio.
Prior to Tuesday, how was the yuan exchange rate set? Each day the, PBOC would state a midpoint exchange rate between the yuan and dollar for that day, and allow the currency to trade within a 4% range around the midpoint. However, they seldom changed the midpoint from the prior day, regardless of how market forces operated the previous day.
Why is this change a concern for U.S. investors? For U.S. companies that export to China, their goods just got 2% more expensive to a Chinese consumer. So they either have to lower their price, which will affect profitability, or they will be less competitive than they were. Moreover, Chinese goods offered to U.S. consumers just got 2% cheaper, which puts more competitive pressure on most U.S. companies. Finally, the change was interpreted by many analysts as an indication that the government believes that economic growth will be slowing down in the future.
Stocks declined Tuesday – what about bonds? Bond prices increased. In our post last September [Market Matters] we pointed out that the correlation between bond markets and stock markets has been negative. Tuesday was a good example of why. If Chinese investors believe their currency will decline further, then they will prefer to put their money in investments outside of China – such as U.S. bonds. That increased demand drives up the prices of U.S. bonds.
Is it “unfair” that the Chinese government devalued their currency? All central banks, including the U.S. Fed, undertake actions to control the value of their currency –for currencies that float more freely, they do so by buying and selling their currency in the open market. To put this week’s decline in perspective, over the past 10 years the yuan has increased in value against the dollar by an aggregate 36%.
What does this mean for your portfolio? There are thousands of factors that affect the values of U.S. stocks – some being more stable than others. The yuan exchange rate is now a more important factor than it was last week. There will likely be some elements of heightened volatility, causing both positive and negative swings, as the PBOC takes further action, and the impact of those actions on U.S. corporate earnings become more apparent. But we view the specific impact of this single change in policy as not being vital to the long-term performance of your portfolio.