CNY devaluation: the Rubicon has been crossed

China’s record 1.9% weakening of the CNY fixing rate has sparked a global risk-off movement, with US bond yields falling to levels not seen since May.

Source: Bloomberg

There has been an incredible rally in US dollar buying with the currency crossed against EMs in particular seeing major moves. However, the DXY dollar index has increased only slightly due to its heavy weighting against the JPY and EUR.

After oil’s bounce on Monday, WTI declined 4.4% and Brent was down 2.8%. This likely reflects concerns over USD strength rather than any fresh concerns over China’s weak economy. All things being equal, major moves by the Chinese government to start propping up its slowing economy (such as record devaluations) are net positive over the longer term, even if in the short term their prices decline in nominal terms due to their US dollar denominations.

Energy and resource equities have not fared well, as Chinese purchasing power for their US dollar denominated products has shrunk. Equities that have significant China exposure, such as luxury brands and car companies, have also seen declines as their product pricing becomes less competitive. Chinese corporates with a large amount of US dollar denominated debt, like Chinese airlines, are also struggling.

The People’s Bank of China’s (PBoC) statement alongside yesterday’s fixing announcement indicated they wanted the CNY exchange rate to increasingly reflect market moves in the currency. If that’s the case, then the USD/CNH 3% rally up to a current level of around 6.4 could see the PBoC further weakening the fixing today. Global markets will be keenly paying attention to today’s fixing announcement at 11.15am AEST.

A raft of important Chinese economic data also gets released today, with retail sales, industrial production and urban fixed asset investment all due to be published. Any misses below market expectations are likely to see further rallies in the USD/CNH.

Markets were not expecting any major moves on the currency from the Chinese government, despite its benefits, as the risks were perceived as too high. Now that this Rubicon has been crossed, keen attention should be paid to any other significant moves to prop up the Chinese economy. Further cuts to the reserve requirement ratio (RRR), PBoC direct liquidity injections through its range of tools (SLF, PSL, MLF, etc), and a ramp up in fiscal stimulus are all possibilities.

The Chinese government has already promised CNY 1.3 trillion in infrastructure spending in the second half of the year. However, a lot of this is the formal issuance of previously off balance sheet local government financing vehicle (LGFV) debt. There is still plenty of room for more direct fiscal stimulus.

Already, we have seen iron prices climb steadily since their record low on 9 July. There are concerns that iron ore demand may be hit, as factories in the Beijing region are shuttered on 20 August in preparation for the ‘blue sky days’ required for the World War II 70th anniversary commemoration (known in China as the ‘Resist Japan War’). However, a lot of steel factories have already been moved out of this area in recent years due to concerns about pollution in the capital. The development of the Jing-Jin-Ji megalopolis connecting Beijing, Tianjin and Hebei has added further impetus to relocate polluting industrial factories out to other parts of China. So the decline in production from the halt may not be as bad as it has been in previous years.

Aussie miners and resource-related stocks are likely to be hurt at the open today, off the CNY fixing news. However, the fact that China is prepared to make unexpected major moves to support its slowing economy and keep the 7% GDP growth target in sight is increasingly a positive for demand going into the second half of the year. And miners like RIO and FMG who have undergone severe cost-cutting measures and have relatively stable finances are well positioned to benefit in this scenario.

The ASX at the open

After yesterday’s 0.65% decline, the ASX is not looking to have a good open. Energy and resources sectors saw major declines in overnight markets, and make up over 30% of the ASX. If CBA’s numbers hurt sentiment in the banks and financials today, which combined with resources make up over 50% of the market, we are likely the see the index move down further.

The bar for the companies to impress the market with their earnings is very high at the moment. Cochlear and Domino’s both saw their stocks hit hard yesterday by not meeting investors’ expectations for continued high growth into FY16.

Cochlear’s earnings miss brought down the whole healthcare sector yesterday. Star performer CSL is reporting today; the concerns are that anything except a major beat of expectations could see the stock decline as well.

CBA’s stock has been performing well this week, with the market pricing in expectations for today’s $5 billion capital raising to bring it closer to its 10% CET1 ratio requirement. However, CBA has the largest lending exposure to the resources sector, and there is the potential for its bad and doubtful debts (BDD) number to increase. ANZ announced a higher BDD number than expected on Thursday, which could indicate CBA will do the same. The stock is halted today due to the capital raising, but its earnings will weigh heavily on the financial sector as a whole.

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