As we have been going through a deep dive of our chart library a surprisingly simple theme has emerged: the Chinese yuan has had a tremendous impact on almost all major asset classes around the world.
Over the past three years the yuan has declined by approximately 10% against the USD. This devaluation episode has dragged down commodity prices, particularly crude oil prices.
Michael Mauboussin: Challenges and Opportunities in Active Management And Using BAIT #MICUS
Michael Mauboussin's notes from his presentation at the 2020 Morningstar Investment Conference, held on September 16th and 17th. Q2 2020 hedge fund letters, conferences and more Michael Mauboussin: Challenges and Opportunities in Active Management Michael Mauboussin is Head of Consilient Research at Counterpoint Global in New York. Previously, he was Director of Research BlueMountain Capital, Read More
The move lower in crude oil prices has driven high yield spreads wider. It seems unlikely that oil prices can shrug off the latest leg lower in the yuan which would suggest that we will see a widening in high yield spreads once again.
When credit spreads widen, inflation expectations have moved lower. The low this year in 10-year breakeven inflation expectations coincided with the high yield spread over 10-year treasury blowing out pass 800 bps.
And this is important for the stock market because inflation trends have been driving the overall stock index in 2016. That is, however, until recently. Since early July, inflation expectations have rolled over while the S&P 500 has popped out to a new high. The obvious question from this chart is can this divergence continue?
Bond investors have enjoyed the weaker RMB as bonds have outperformed stocks as the yuan has slipped lower. The current level of the yuan suggests that the bond market is set for another period of outperformance against stocks. From a time perspective this lines up well with the fact that the market is entering the most seasonally difficult period over the next several months.
Due to the chain reaction of a weaker yuan, the yuan has also impacted stock market leadership. Cyclical stocks and crude oil prices tend to move in a pretty tight relationship. As crude moves lower, cyclicals underperform.
So what benefits in a lower oil price environment? Growth counter-cyclicals. Growth counter cyclicals (health care and staples) have outperformed cyclical stocks by 42% over the past five years as crude has moved from approximately $120 per barrel to $50 per barrel.
In a weaker yuan world, finding diversification through broad country exposure is difficult. The US is the only broad market country that outperforms.
However, there are certain foreign pockets that work well. For example, Asia (80% Japan) health care and consumer staples have outperformed the overall GKCI DM Index while the yuan weakens.
Probably the least surprising fact to investors is how a weaker yuan leads to emerging markets underperforming as a group. As China implements a “beggar thy neighbor” currency policy, China’s “neighbors” in the EM are going to feel the brunt of the pain. EM stocks have underperformed DM stocks by nearly 16% over the past four years.
However, again select EM groups work and once again that group is growth counter-cyclicals
So the risk facing investors right now is this: if as Bryce laid out yesterday the path of least resistance for the yuan is weaker, what is the reaction chain going to look like? If it plays out like it has over the past several years then a weak yuan will exert a gravitational pull on a lot of different assets and it would most likely lead to lower oil prices, higher credit spreads, lower inflation expectations, and continued outperformance of counter-cyclical stocks and US stocks.