Debate has raged surrounding the rationale behind China’s currency devaluation. One interpretation puts this week’s moves down to political considerations, with China seeking to create a more market-driven exchange rate that would allow its currency to gain admission to the IMF’s Special Drawing Rights basket [1].
Nonetheless, markets have focused on the possibility of further steep declines in the renminbi, and we are mindful that the change in Chinese monetary policy may also be indicative of weaker fundamentals and the deteriorating health of the economy. Slowing GDP growth is backed up by anecdotal company feedback which points to a considerable contraction in Chinese trade data, with export and import levels both meaningfully lower. As a result, global risk premia may need to adjust higher to reflect lower global growth. This could see an acceleration of emerging market stress which is likely to continue to have a negative impact on commodities and energy prices.
Risk of deflationary pressure
One consequence is that we may see deflationary pressures re-emerge. These are also in evidence from lower factory gate prices (producer price index) in China which are currently at -5% year on year. Emerging market contagion, currency wars and the potential for spill over into the Asia Pacific basin represent a wider risk to European equities. A more pronounced period of competitive devaluations cannot be entirely ruled out as the renminbi is generally regarded to be some 5-10% overvalued against the dollar, but the gap is much more considerable against other emerging market currencies.
On the other hand, another scenario is that imported deflationary pressure into the eurozone and adjacent economies such as the UK could lead the European Central Bank to extend its quantitative easing policy. This would likely be supportive for sentiment towards eurozone equities. Additionally, the risk of an extreme devaluation would be nullified if the authorities’ intention is simply to create a more flexible exchange rate.
Eurozone exposure to China is moderate
Around 6% of total eurozone exports go to China, with some 10% of the region’s imports coming from China (source: Citibank). While this is not immaterial, the overall level is fairly moderate and highlights the fact that domestic intra-eurozone trade is far more important to eurozone GDP. Further currency devaluations would act as a headwind to export pricing, but cheaper imports may offset this and support domestic consumption in the eurozone.
Moreover, we need to ensure that perspective is retained over the Chinese devaluation. Given the euro’s weakness against the dollar over the past year, the euro has in fact depreciated by c.2% against the renminbi over the last 12 months and is nearly 9% weaker over the past two years. Consequently, eurozone exporters are still enjoying currency tailwinds at current levels.
Figure 1: Euro versus yuan
Source: Thomson Reuters, 12 August 2015
In terms of eurozone equity exposure, detailed data is limited. It is estimated that c.12% of market cap weighted sales (for Eurostoxx 50 companies) go to the Asia Pacific region, with only 2% going directly to China. We should note that these figures capture only direct sales, and do not fully reflect value added domestic sales that may ultimately become China exports. However we would estimate the exposure to earnings to be slightly higher, approximately 6%. Once again, this demonstrates the reliance on domestic European trade (c.59%). Hence we anticipate only a moderate impact from the foreign exchange move on the wider eurozone markets.
Luxury goods and autos among the most affected sectors
That said, within this there are sectors and companies that have significant exposure. These include sectors such as luxury goods, technology, automotive, capital goods and materials (mining and chemicals in particular). For these, translated profits will be impacted but it is also possible that competitive transactional disadvantages may emerge due to revitalised competition (for example, this could impact some industrial and chemical companies which face strong Chinese competition). Whilst the dispersion is wide across the eurozone, there are many domestic industries that have by definition limited or no direct exposure including banks, insurance, travel, media, utilities and telecom services to name but a few.
Figure 2: Eurostoxx 50 sales by region
Domestic eurozone exposure is preferred
In terms of our positioning, we have a clear preference for stocks with eurozone exposure, including banks, which have improving momentum amidst the domestic recovery. Meanwhile, consumer resilience in the eurozone is well underpinned thanks to the stimulus offered by low or negative interest rates, cheap oil, rising bank credit impulse and pent-up demand from the recovery of peripheral Europe. By contrast, we have limited exposure to luxury goods and automotives which should prove beneficial if these sectors continue to lag the wider market.
As ever, we remain on the lookout for mispriced opportunities, and future foreign exchange induced stock market volatility may well lead to exaggerated movements which can be exploited by active managers.
