After years of small-scale strengthening against the U.S. dollar, the coordinated devaluation of the Chinese yuan has come when China’s economy is seeing more signs of weakness. In our view, it’s hard to believe that the recent devaluation of the yuan will significantly help the Chinese economy. In addition, relative to the last several years, the yuan is still strong against the euro and the yen. This raises the question: Is there more devaluation to come?
Clearly, growth-rate expectations for China’s GDP have come down (see chart below). The forecast is for 6.9% growth in 2015, versus 7.4% in 2014. Moreover, recent auto-sector and consumer data were weaker than expected. We believe the government’s push for a shift to more consumption-based growth (away from investment-led growth) is still high on the agenda.
The most-significant results of the yuan devaluation may be related to commodities and some of China’s trading partners, as the knock-on effects from lower Chinese demand may continue to hurt certain emerging-market countries—where less demand for commodities such as copper, other metals and oil may slow the economies and devalue the currencies of countries that have significant ties to China.
Equity Markets and Wasatch
As we discussed in several of our commentaries this year, we became convinced that stock-market bubbles had formed in Shanghai and Shenzhen, which were transmitted (to a lesser extent) to Hong Kong. In the last two months, sentiment has worsened for all China-related stocks on poor data, poor equity-market behavior and intervention by the government. Therefore, we’re pleased that we’ve maintained significant underweights to China versus our benchmarks.
As fundamental investors at Wasatch, our emerging-market approach tends to look at more domestically focused (as opposed to export-oriented) companies as a general theme. Yet we do hold some export-oriented companies in countries where, if China were to continue the yuan devaluation, the companies may well be affected. Therefore, we’ll continue to watch these companies closely.
As discussed above, our relatively underweighted Chinese allocations put us in a better position if both the Chinese currency and stock markets continue to weaken. Nevertheless, we need to keep in mind that China’s problems are not confined to just China itself. There are many emerging markets that are tied to China’s growth. For example, Chile has seen its economy driven by copper exports, and copper prices have been generally dropping in recent years. So any incremental decrease in demand from China (which makes up as much as 20% of Chile’s copper exports) would cause further pressure on the Chilean economy and currency. Other countries with similar exposure to various commodities are Peru, Brazil and South Africa, all of which may also see additional pressure on their economies and currencies if there’s an extended devaluation of the Chinese yuan.
We’ve been wary of such potential challenges, and thus are generally less exposed to these countries versus our benchmarks. Wasatch tends to be overweighted in countries that benefit from lower commodity prices. For example, India is our largest country weighting in most of our emerging-market portfolios, and the country has 50% of its import balance in fuel. We’ve also invested in countries (e.g., Mexico and Taiwan) that have significant exports to the U.S.
We’ve frequently commented on our fundamental analysis leading us more to companies focused on domestic demand (in the Philippines and India, for example) where there are strong, favorable demographics. We believe this leaves us less exposed to shorter-term currency fluctuations as the secular rise of a large middle class in many of these countries produces excellent long-term growth prospects in well-run companies. These companies have been the hallmarks of the Wasatch stock-selection process.
Wasatch Portfolio Positioning
Relative to our benchmarks, we continue to be underweighted in China and Hong Kong. We believe China is a “structural” underweight based on our quality and growth concerns. In terms of the names we do own in China, we’ve become more defensive. We do not think now is the time to be aggressive buyers of Chinese stocks, whether they be listed in China, Hong Kong or the U.S. In some ways, we think there are parallels with Japan in the 1990s, as that country worked its way through credit and property bubbles.
In a nutshell, our long-time underweights in China have related to: (1) our fundamental research of the companies we analyze and visit there, and (2) our concern that property and equity bubbles were forming in China earlier this year. As you may know, Wasatch generally doesn’t hedge currencies in its portfolios. Nevertheless, as described above, we have strategies to deal with the ripple effects of a weaker Chinese yuan on other emerging- and frontier-market economies and currencies.
Information in this document regarding market or economic trends or the factors influencing historical or future performance reflects the opinions of management as of the date of this document. These statements should not be relied upon for any other purpose. Past performance is no guarantee of future results, and there is no guarantee that the market forecasts discussed will be realized.