Week End Blog – China Wreckage!

Well, this has turned out to be quite the week in financial markets. China decided to spice things up a little, as it depreciated the Renminbi. What could (unknowingly) be interpreted as a minor adjustment, Wednesday’s devaluation was less than 2% against the USD, caused major damage. But that’s probably because the move by China is, in fact, everything but minor. First, the one-off adjustment was followed by two smaller ‘one-off” devaluations. Second, the biggest of the nine previous currency adjustments equaled 0.36% against the USD. Third, China’s move will reignite, at least to some extent, currency wars. Vietnam has already widened the Dong trading band.

The damage of the devaluation was visible around the globe. European stocks, led by its export engine, Germany, plummeted 3% on Wednesday, emerging equities and currencies got slammed as well, and luxury brands were right at the top of the ‘losers’ list.

So what’s the reason behind the China move? Well, of course, it’s about freeing up markets to attract foreign investors, blah, blah, blah, but I guess the four charts below also have something to do with it. China’s economy is slowing, and perhaps a bit too fast. So after massive interventions in the equity market, China is now targeting exports as well.

Making your own exports more attractive means exports of others must become less attractive. Just ask Brazil. More than half of all Brazilian exports are heading for China. The country can’t be too happy with its fellow BRIC right now.

Besides, Brazil has problems of its own. For example, inflation is still rising and approaching 10%.

Also, Brazil’s economy and budget are a mess. So Moody’s, vigilant as ever, decided to downgrade Brazil’s sovereign debt to Baa3, which is precisely one notch above junk status.

And, with commodity prices still falling, things could turn even more ugly going forward. This week, crude oil hit a six-year low. The IEA reported that the supply glut is to stay with us well into 2016. Almost everyday I read headlines stating that oil supply and production is beating estimates.

Ever since OPEC decided not to lower production, back in November of last year, the oil market has turned into a game of chicken. The two main players being Saudi Arabia and the U.S. shale industry. I wrote a blog on this topic this week in which I try to substantiate that, contrary to expectations, U.S. shale companies could be winning. The jury is still out, but what has become clear is that shale production is very resilient.

Lower oil prices also mean lower inflation expectations. The two graphs below show that US and Eurozone inflation swaps have come down sharply once again. On top of that, China’s move to devaluate its currency, is ultimately deflationary as well. If the Fed wants to postpone a rate hike it could have found a second reason to do so. The other being wages.

No ‘Week End Blog’ is complete without Greece. Especially when there’s good news related to the country. First, a third bail-out package looks imminent, although the Germans, as always, still have doubts. Second, the Greek economy grew (yes, getting bigger) in the second quarter. GDP increased 0.8% compared a 0.5% decrease expected. I know, this will not last, be let’s enjoy it while we can!

With a third bail-out deal on the horizon, the question arises: ‘Will this time be different?’ As the graph below shows, Greek banks have not done particularly well after the first two bail-outs. Banks must be recapitalized fast, but the real challenge is to prevent us all from reliving the last couple of months a few years down the road. Let this time BE different (hint, haircut).

Last, but not least. Partly due to global QE, partly due to changes in regulation, investors have taken a one way bet in (credit) bonds. This has led to significant changes in market characteristics. A sharp reduction of liquidity is one of the most explicit ones. Citi strategist, Matt King (who knows what he is talking about most of the time), wrote a research paper on this issue. The tweet below holds a link to a summary of that research piece which I can really recommend.

Thank you for reading the Week End Blog. I am off to a short holiday in the Belgium Ardennes. Enjoy your weekend!

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