As we enter the second half of the year, one of the major events we are preparing for is a Federal Reserve rate increase.
Historically, equity markets have undergone modest corrections when Fed rises began. With time, it became clear that sufficient growth accompanied higher wage and price pressures, and that the Fed was going to keep inflation under control, equity markets rebounded.
The size and complexity of the monetary experiment is much different this time, so we need to be prepared for outcomes that vary from the standard script. But as a starting point, this time, the Fed can afford to be patient given inflation rates at the current low levels.
Market disruptions instead might come from events such the recent Chinese market fluctuations. We believe the recent volatility is due to several reasons, among which are lower GDP growth exacerbated by weak imports, disappointing Chinese PMI, and bearish investor positioning following the recent margin trading led market boom.
In our portfolios, we remain constructive on the medium-term outlook for emerging Asia, but the break in confidence caused by the recent correction in Chinese A-shares has made us more cautious on the Asian market outlook over the next few quarters. Visibility in Europe has improved, as political and policy risks have lessened. We believe that the opposite is now the case for China, and by extension broader Asia.
We believe that the recent Chinese move is not so much aimed at boosting exports, as a yuan depreciation of less than 5 per cent will have a marginal effect on improving competitiveness. If boosting exports had been the target, China would have moved more aggressively in one go or would not have kept intervening in forex markets as it has over the past years.
In our view, the motivations were more domestic than external – loosening tight financial conditions or mitigating Fed’s lift-off. Furthermore, we believe implementing more liberalisation gets the Chinese currency closer to SDR [special drawing rights] inclusion, as per the IMF’s recommendations.
Going forward, the government might respond with further rounds of loosening measures, such as reduced bank reserve requirements and other support for banks, fiscal stimulus financed at the federal level, and pressure on local governments to deploy available cash into more infrastructure projects.
We expect that this is the beginning, not the end, to the weakness in the yuan. China is now embarking on the same path as other economies in the region. To push the effective exchange rate back to levels before the US dollar began its ascent, we believe a yuan weakening is warranted and China will choose a gradual path to depreciation.
We saw the reverberation across the globe from last week’s moves, with heightened volatility across many asset classes, and a flight to quality in the short term, with anything China- or commodity-linked further pressured. In the medium term, we believe a weaker Chinese currency will continue to put downwards pressure on inflation and impact on commodity-exporting economies meaningfully.
This also has implications for the Fed in its timing for the first rate increase. The events last week give us further conviction that a rise in the face of heightened global tension is unwarranted, and we firmly believe that the first increase will be in December. The Fed would not risk an increase that could create a potential disruption into an already challenging environment.
Market wise, the current devaluation means that equity risk premiums will go higher globally. However, we believe that, while the uncertainty might temporarily derail equity multiples, developed markets growth will remain intact.
Cesar Perez is the global head of investment strategy at JP Morgan Private Bank.
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