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Little Trouble in Big China

It is obviously time for another update. I haven’t been an active poster recently, because as many of you know I am busy working on a book for the Wiley label. I am about 80% done; however, it is very time-consuming! The title of the book is (tentatively) What’s Wrong with Money?: The Biggest Bubble of All – and How to Invest with it in Mind, and if you would like to be on the notification list to receive an email when the book is published, simply send an email to WWWM@enduringinvestments.com. Even better, you can pre-order it already apparently, even though it’s not due out until later this year or early next year. (No pressure, huh?)

So, I have been embroiled in the writing and editing process, and not posting much. This will change soon, but China’s overnight move to (slightly) devalue the yuan is significant enough to warrant a post. There are also some other topics that need a quick mark-to-market, but I will save those for another day.

China’s move is possibly qualitatively significant, but I don’t believe it is yet quantitatively significant. A two-percent move in a currency is barely worth recording – it is almost within the daily standard deviation band of some currencies! So, when you have read about how this dramatically changes the inflationary concern of the Fed to a deflationary concern…that’s nonsense. The Swiss Franc strengthened by 20% against all currencies, in a single day, back in January. Since then, the core Swiss inflation rate has moved from +0.4% y/y to -0.6% y/y. Also note that Switzerland’s imports amount to about 50% of its GDP.

Let’s take that as a back-of-the-envelope scalar just to do a rationality check. A 20% change in exchange rate affecting about 50% of goods and services caused a 1% move in core CPI.

The U.S. imports about $40bln in goods from China per month, out of an annual GDP of $16.3 trillion. So in this case, we have a 2% move in exchange rate affecting about 2.9% of domestic goods and services. So if the effect was linear, we would expect about 1/10th * 1/17th * 1% of a move in core CPI as a result of the Chinese action. Check my math, but that would seem to be about 0.006% movement in expected core inflation as a result of China’s revaluation. Negligible, in other words.

Now, qualitatively the effect might be higher if, for example, this presages a more-significant move by China. But even assuming that the exchange rate moved ten times as much, you are still talking about rounding error on inflation. Sure, the effect might not be linear but the essential guess is that from a price perspective we don’t care.

Certain companies and industries and goods, of course, will see a much bigger effect (it would be hard to have a much smaller effect), but it shouldn’t be a big deal – even if it is part of a larger move. From the standpoint of economic growth, it may matter more…but even so, a 2% change is unlikely to matter as much as a 10% change in shipping costs, and moves like that happen all the time.

China is a big economy, and a big trading counterparty of ours. But the U.S. is still a significantly-closed economy. While China represents about 20% of all of our imports, imports as a whole only amount to 14% of US GDP. So, in summary: this is an interesting moment politically, if China is signaling a willingness to float her currency. It is not a particularly interesting day macro-economically, at least from the standpoint of the effect on prices of this move.

The China Syndrome

The last month or two has provided a wonderful illustration of why a diversified commodity index is a better investment than an investment in any given commodity. Since mid-February, April Lean Hogs has rallied 23%. Since late January, May Wheat is up 23%. March Coffee is up 80%. Gold is up 9%. But Crude Oil is 6% off its highs. Copper is 12% off its highs (8% since Thursday). April Nat Gas was up 42% from November through late February, but has lost 10% since then.

This is great if you happened to be 100% in Coffee, and bad if you happened to be heavy into copper or RIO or BHP. But this sort of volatility and non-correlation is exactly where much of the return to commodity indices, over the long run, comes from. Later this month, commodity indices will sell coffee and buy copper, systematically buying low and selling high. This phenomenon is worth on average a couple of points of return per year.

Most commentators seem to be focusing on the precipitous decline in copper prices, supposedly because “Doc Copper” is supposed to be a good leading indicator of economic growth. But in this case, the behavior of copper is mostly due to quasi-panic over China’s recently flagging growth figures. Although China is not the only consumer of copper (although sometimes you might think so, from the news coverage), prices are set at the margin and if there was an actual recession in China as opposed to a modest slowdown, then this would push copper prices lower.

But that would be terrific for Europe and the U.S., because it would mean cheaper copper for us. Similarly, decreasing Chinese growth would relax some pressure on energy prices, which would also be a boon for the Western world. I think people forget that one of the key reasons the “Asian Contagion” from the 1997 Asian Financial Crisis never happened (U.S. growth “bottomed” at 4.1% in mid-1998 – a level it hasn’t reached since 2004) was not because of Federal Reserve action (from March 1997 until August 1998, the Fed Funds target never budged from 5.5%) but because commodity prices plunged from 1997 into 1999. The DJ-UBS index fell from around 128 one month before the Thai baht collapsed to 75 in the first quarter of 1999 (see chart, source Bloomberg).

djubsbaht

Even worse (or better, depending on your perspective) was the decline in energy. Crude oil dropped 55%, from the $25 area at the beginning of 1997 to $11 by late 1998. That remains the lowest real price of U.S. oil recorded since 1946 (see chart, source Enduring Investments using data from Dow Jones and the Bureau of Labor Statistics).

wtirealIt may be impolitic to say so, but probably the single best thing that could happen to U.S. growth would be for Chinese growth to slow, pushing the price of important commodity prices lower. As a nation, we consume far more commodities than we produce, so lower input prices is a net positive.

However, I suspect this is much ado about nothing. Chinese growth, even if it slows, is likely to remain plenty hot enough to keep commodity prices from falling very much, even in real terms. Real commodity prices have been falling steadily since 2011 (which is why all of the talk about the “end of the commodity supercycle” a year ago was so humorous) until early this year, even while the amount of currency in circulation has steadily increased. It certainly seems to me as if we have priced commodities fairly conservatively, and they can probably withstand a growth slowdown in China as long as the country doesn’t enter a bona fide crisis.

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