China's currency reset is a game-changer

Don’t ask me where things are the best. That’s the wrong question. Ask me where things are the most miserable.
— Sir John Templeton

There was really no new economic data here in the U.S. to justify the 1,000 point slide in the Dow Jones on Monday, August 24 after a 500 plus decline the prior Friday. So what caused such a dramatic plunge? Every self-professed market expert on CNBC has an answer but no one really knows. Some of the explanations I find compelling are China’s currency devaluation and the markets simply being pricey — as in all market corrections, investors were merely selling as prices kept falling. 

One fact is certain: we learned this past week that the US is not as insulated as we thought from China’s slowdown and the continued economic malaise facing emerging markets. After all, global consumption for every commodity has been driven by China and largely supplied by many emerging markets.

China devalues
Fears that economic conditions in China are worse than investors originally thought resurfaced when the People's Bank of China (PBoC) decided to suddenly reset its currency. This move sent the currency markets into chaos and was cause for investors to reevaluate all risk assets. Indeed, the poor communication from the PBoC over China's currency intentions has been a key cause of financial market turbulence.

I believe China’s currency devaluation was a game-changer for global markets. The sudden move by the PBoC has negative effects for companies with significant production in China. It could also be an even greater drag on U.S. multinationals earnings growth by reducing China's demand for our exports.

Conversely, by devaluing its currency, China intends to regain competitiveness and boost its exports. I have provided a link below to a recent Bloomberg News QuickTake article entitled "The People's Currency: Freeing China's Yuan" — it provides an excellent historical synopsis and further explanation behind China's recent currency reset.

A Relapse of Investor P.T.S.D.
Investor confidence, once again, has been damaged by extreme market volatility, just as it was during the “flash crash” on May 6, 2010. And while it's been almost seven years since the financial crisis of 2008, many investors have yet to recover from the trauma of the near collapse of our financial system. Do you remember that between October 2007 and March 2009, the U.S. stock market dropped in price by over 50%?

Panic set in on Monday as markets were abruptly awakened from their summer of complacency. In an Investor’s Business Daily editorial, Stephen Porpora, a member of the NYSE for 31 years, made the following observation — “It's not that markets went down — it's how they went down. Certainly, fears of a China slowdown, devaluation, etc. are real. Yet, Monday's volatility was such a wild ride that even seasoned traders and financial news commentators were left shaking their heads. As just one vivid example, KKR & Co., the asset management firm, traded from a high of $19.43 to a low of $8.00 and closed at $19.50 on Monday, August 24th. Yikes!"

Market volatility reached levels that we haven’t seen since 2011
On Monday, the CBOE volatility index (often referred to as the “Fear Index”) surged and crossed the 50 level for the first time since February 2009. Sudden spikes, like those illustrated in the chart below, are not to be taken lightly--they are not just indicative of “manic” market behavior or panic-selling. Indeed, I take such market behavior very seriously.

  Source of chart: CNBC.com

Source of chart: CNBC.com

Now for some positive news...
On Wednesday, August 27, The U.S. Commerce Department released revised GDP estimates for the second quarter -- the economy grew at an annual pace of 3.7% vs. the original estimate of 2.3%. The market recovered another 369 points on the Dow by the close on Thursday after closing up 600 points on Tuesday and the S & P closed up 47 points or 2.43%. Here are some more economic positives to ponder:

  • The U.S. should continue to be the engine for global growth—economists surveyed by Bloomberg expect annual GDP to average 2.3% this year.
     
  • The US consumer is doing modestly better – housing is stable and showing signs of strength –much needed at this juncture. Signs of overdone credit expansion are absent from this cycle.
     
  • While the market was overvalued in certain areas, such as biotech and industrials, valuations are not as stretched as they were during the housing bubble and dot com era.

Unless market turmoil continues and undermines business sentiment, I believe this past week is just a healthy market correction. However, the market could continue to struggle in the coming months as it reassesses risk asset valuations against the backdrop of future U.S. interest rate hikes, China's slowdown, and signs of peaking U. S. corporate earnings. 

Our bottom line
Stock prices follow earnings and the path of corporate profits over the next few quarters will tell us whether the bear’s claim that stocks have peaked is true. It’s important to remember that investing is about managing risk. Maintaining a globally diversified portfolio that matches your risk profile is critical, especially in the current environment.

It's also important to keep a calm, clear perspective during times of heightened market volatility. Take the time to reassess your investments with your advisor as you may be overweight equities due to strong market performance over the past few years. If you are confident with your advice and holdings, you can avoid capitulating and selling into a panic selloff.

The sudden move by the PBoC to devalue its currency is, indeed, a game-changer for global markets, and we are headed for some heightened volatility. I will continue to be vigilant in the months ahead.

Sources: The Wall Street Journal; Bloomberg News; Investors Business Daily; CNBC.com.

Observations and views expressed herein may be changed at any time without notice and are not intended as investment advice or to predict future performance. It is not an offer, recommendation or solicitation to buy or sell. It is based on information generally available to the public from sources believed to be reliable. Changes to assumptions may have a material impact on any returns detailed. Past performance is not an indication of future returns. Please consult your financial professional before making an investment decision.