A Brief Risk Update: Trade War Update
Over the last several years, numerous commentators have expressed concern that China could retaliate against any U.S. trade threats by liquidating their U.S. Treasury holdings and thus causing U.S. interest rates to spike. We did not view this as a credible threat, as such an action would involve selling dollars and purchasing Chinese currency, Chinese Yuan (CNY), thereby causing the CNY to appreciate. This is a bad strategy if you are an exporting nation. Roll the clock forward to today. Rather than respond to U.S. threats and actions by selling U.S. Treasuries, China is doing almost the opposite – they are depreciating their currency, allowing it to decline almost 7% since the onset of the trade conflicts.
It appears as though the Chinese have decided to combat rising U.S. tariffs with currency devaluation, thereby allowing goods prices in dollar terms to remain fixed. This devaluation is in turn disrupting currency valuations, placing upward pressure on the dollar and downward pressure on a broad range of Emerging Markets (EM) currencies, thereby creating a significant headwind for EM risk assets.
How long should this be considered a viable strategy? It’s unclear. While the strategy creates obvious risks for many of China’s smaller trading partners, it also creates the risk of capital flight in China – something they were combatting as recently as a little over a year ago.
While interest rate differentials and flight to quality conditions can cause the dollar to appreciate over certain periods, the long-term trend should be clear – and it is down. The persistence of the U.S. trade deficit should continue to place downward pressure on the dollar; however, recent trade conflicts and political risks (in Europe – Italy) have disrupted what we view as a longer-term trend. As long as dollar appreciation holds, EM risk assets will face headwinds. Further evidence of this can be seen in the market response to the President’s recent comments that a weaker dollar would be in the U. S.’s best interests – the dollar has fallen and EM equities have spiked.
Although the current rhetoric has been volatile, the fundamentals behind our investment thesis in EM remains intact with the underweight to ex-U.S. developed markets providing more than adequate protection as demonstrated in the past quarter. Our thesis would change in the event that we are able to identify any material deterioration in the underlying fundamentals. Although current sentiment is negative, for now, we believe compelling valuations along with strong earnings growth support the case for an EM overweight. We anticipate that something approximating a rational outcome will eventually be achieved, but the ride will likely continue to be bumpy.
This information was prepared for informational purposes only and does not contain investment advice. The opinions contained within this document are those of Pavilion Advisory Group Inc. (Pavilion). No investment decision should be made based on this information without first obtaining appropriate professional advice and considering your circumstances.
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