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Currency: The Not So Lucky Seven


In the ongoing escalation of trade tensions between China and the United States, we now have a broadening component – currency. China announced it was relaxing the boundary it would float their currency and thus devalued it to counteract the recent tariff increase and protectionism imposed by the United States. The Shanghai Composite has lost 4.51% in the first six days of August but is still up nearly 14% year to date.


Overnight the fixed rate was brought back down below seven yuan to one U.S. dollar after setting it above the Lucky Seven level which hasn’t been seen in 11 years. The chart below shows the Reserve Ratio for Banks in China and the yuan, which has devalued as the interest rates have dropped (required more yuan to 1 U.S. dollar). Academics will be ecstatic with this correlation.


lloyd3_080619 

This has not been the case with regards to the dollar and the Fed Funds Rate. Notice that the currency markets typically were forecasting the Federal Reserve cutting rates well in advance and took the value of the dollar down, except for a few occasions. Most notably was the 2001/2002 time period which was marked by the U.S. recession and stock market correction from the Tech runup of the 1990s. However, it did not translate to a global recession. According to the International Monetary Fund (IMF), since World War II we have only seen global recession four times: 1975, 1982, 1991 and 2008. This is important when looking at the current situation and the anxieties that it spirals into a global recession.


The declaration of the United States that China is a currency manipulator in response to letting the currency “float” above seven yuan to one U.S. dollar took markets to “DEFCON 2.” As the world waited for China to respond negatively, they set the limit just below seven. What may confuse some is that if the Peoples Bank of China (PBoC) is setting where the currency can trade and they adjusted it in response to the manipulator claim, does that not prove the case the United States is making against them? We will leave this rabbit hole alone as there are more complexities to it, however, there is a case (no matter how peripheral it may be) that all countries are manipulators to some degree.


lloyd2_080619


So, while this latest move by both countries has escalated the trade tensions beyond just trade and made it a currency scuffle, keep a few things in mind:



  • In China the ongoing broad-range stimuli to an already stimulated economy is much like an overinflated tire that is not quite getting traction. Between tax cuts, interest rate cuts and liquidity injections or swaps, this ultimately creates a floor to the economic slowdown they are experiencing.

  • The U.S. consumer is doing very well as evidenced by personal consumption up 4.3% and personal income up 4.9% year over year. The average increase in personal income since the end of the last recession is 4.2% growth annually.

  • There remains ample liquidity in the system:

    1. U.S. Households and Non-Profits hold $13.25 trillion in total liquid assets and deposits, total assets of $124.6 trillion compared to total debt of just $16.05 trillion.

    2. U.S. Banks hold $1.67 trillion in cash currently.

    3. According to Moody’s, in June 2019 U.S. non-financial corporations held $1.685 trillion in cash; off its highs of 2017 but up significantly from the $720 billion in 2007.

    4. China currently holds $3.1 trillion in currency reserves which assists greatly in influencing rates and adding liquidity. This has grown at an annual rate of 15% over the last two decades, though it is off its high of nearly $4 trillion five years ago. 




The one thing that this disarray is not doing is having an impact on Conference Board consumer sentiment which rallied significantly from the previous month’s drop, and perhaps as importantly the Financial stress index from the St. Louis Federal Reserve. Though these indicators have yet to be measured with the recent trade escalation, both metrics continue to point to fundamental positives for growth, albeit against an increased headwind.


The markets are always pricing in future events, though not efficiently since emotion driven by a negativity bias always exacerbates the move downward. It can do it on the upside as well when the fear of missing out drives irrational behavior like Y2K, South Sea Bubble and Tulip Mania, to name a few. Any conclusion drawn in a short-term perspective can be shredded with one tweet, one agreement or one headline. As such, the one way to combat this and put the probability of success in the investor’s favor is to have a longer time horizon.


CRN: 2019-0806-7603R


This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information at commentary-disclosures. For additional commentary or financial resources, please visit www.aamlive.com.

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