China apparently shocked some people last week by allowing the Yuan to fall 3.5% against the dollar. I don’t know why in the world they would be shocked since we’ve known for months – heck almost a year now – that capital has been leaving China. I wrote about it back in March so it isn’t like it was exactly a state secret. And as capital flows out, to maintain the Yuan/Dollar relationship, the PBOC has to sell dollars and buy Yuan. Apparently they got tired of watching their dollar reserves fall on a daily basis and let the thing drop a bit more than usual last Tuesday. Then they supported it the next day and said the market would play a bigger role in setting its value. In other words, we aren’t going to spend all our reserves supporting this thing. That ought to stop the capital outflows (sarcasm alert).

What is interesting, is that for nearly a year the PBOC has been selling Dollars in favor of Yuan and the Treasury market continues to function. Why is that surprising? Because to sell Dollars, the Chinese almost have to sell Treasuries – their dollar reserves aren’t just sitting in a vault – and people have been telling me for years that once the Chinese start selling Treasuries it’s game over for the US economy. In the face of that sustained selling I’d say the Treasury market has performed admirably and that means someone – quite a few someones – must be pretty negative on the US economy to be buying Treasuries in such quantities. I would think too that if last week’s devaluation is the beginning of a trend – and I think it probably is – Treasuries will start to perform even better as the Chinese selling abates.

The Chinese, as I said in that earlier commentary, are in a bit of pickle though. They don’t want the Yuan to fall too much, too fast because they want the currency to play a larger role in international finance. Currencies that are subject to sudden, surprise devaluations probably shouldn’t apply for that position. In addition, Chinese companies have run up a large dollar debt tab and devaluing the Yuan will make those debts harder to repay. I don’t know if they’ve been able to refinance any appreciable amount of that debt into Yuan but that suspiciously stable period the Yuan just exited might have been the central bank giving them time to do so. Only time will tell on that front but I have my doubts. Maybe last week’s bobble was a warning to speed up the process.

Whatever the case, I think the fears about the potential fallout from a Chinese devaluation are overblown. I don’t know who was selling stocks on this news last week but I’d love to hear their rationale. What? It took a devaluation for you to figure out the Chinese economy is slowing? I’ve got news for you; that isn’t news. Don’t get me wrong; I think there are plenty of reasons to sell US stocks – and buy bonds for that matter – but a Chinese devaluation does not make the list. The Yen is down over 40% against the dollar since 2012. The Euro is down 20% since early 2014. The world did not end and a 3.5% drop in the Yuan isn’t reason to start watching Doomsday Preppers either. Well, okay, there is no reason to start watching that trash, but you get my meaning.

Slowing Chinese growth and a stronger dollar are not things to be feared but rather to be encouraged. Slower Chinese growth has translated into lower commodity prices which will benefit large swaths of the planet. The demise of the debt financed, wasteful government spending, centrally planned style of growth China has experienced since the 2008 crisis should not be mourned. We should cheer if global growth shifts from resource extraction to something more cerebral, productivity enhancing and sustainable, something driven by the private sector.

Now that isn’t to say there won’t be some pain in that transition or even that the transition will happen – it certainly hasn’t started yet – but that is the path back to real growth. There certainly will be pain and one need only observe Dilma’s approval rating down in Brazil to find evidence of it. You could also take a trip to West Texas or North Dakota or talk to the Bank of Canada. The resource boom is over but we haven’t done anything to encourage the transition, fearing the costs are too great for the public to bear.

Of more importance to US stock and bond investors is the state of the US economy (see the Bi-Weekly Economic Review) which is in its own transition. In a lot of ways we face the same transition as the so called resource economies. A large part of our growth the last few years has been driven by the energy sector which is suffering right now with no signs of imminent relief. Of particular concern should be the effect on the bond market where junk bonds have fallen into a steady downtrend. Despite what you may have heard, it isn’t just energy related bonds getting hit and it isn’t just junk either. One of the consequences of living in an indexed world is that there is little in the way of discrimination in markets anymore. Investors aren’t selling energy bonds; they’re selling an asset class called junk bonds or corporate bonds. And so a problem for low rated energy companies turns into a problem for all low rated companies. And that translates into slower growth as the marginal firm can’t get financed.

That’s how fear of a slowdown in the oil patch creates an actual slowdown in the general economy. But that won’t happen overnight and spreads right now are probably not wide enough to cause any significant problems except at the far margins. The economy though hasn’t improved much as we’ve moved through the summer, something that was high on the list of market and Fed expectations. The US economy is teetering between growth and contraction. If we are to avoid recession, it would seem fairly critical that the junk/corporate bond market start improving – or at least stop getting worse. If not, if credit spreads continue moving wider, the Yuan will be the least of our worries.

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For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, Joe Calhoun can be reached at: jyc3@4kb.d43.myftpupload.com or   786-249-3773. You can also book an appointment using our contact form.