China’s economy is tanking … what a weaker yuan means for the dollar … why a stronger dollar is a headwind for your portfolio … investors are back to bullish – and why that may not be great
China’s economic problems are growing, and before you dismiss it as a non-issue, there’s a strong chance it’s impacting your portfolio…with downside to come.
First, let’s make sure we’re all on the same page.
Here’s The New York Times:
China has released a string of worrying economic data.
Prices consumers and business pay are falling, raising the threat of deflation. Retail sales and industrial production in July missed economists’ expectations, and investment in real estate is plunging…
“The Chinese economy is faced with an imminent downward spiral with the worst yet to come,” analysts at the investment bank Nomura wrote in a report on Tuesday.
Fearful of this “worst yet to come,” earlier this week, the People’s Bank of China cut a key interest rate by the most since 2020. The move was unexpected and reveals how dire the situation is becoming.
Here’s Bloomberg:
The People’s Bank of China lowered the rate on its one-year loans — or medium-term lending facility — by 15 basis points to 2.5% on Tuesday, the second reduction since June.
All but one of the 15 analysts surveyed by Bloomberg had predicted the rate would stay unchanged.
The economic situation is becoming so bad that Beijing has announced it will stop publishing data on the youth unemployment rate. This decision comes after that gauge hit a record level a few weeks ago.
Clearly, this is becoming an economic and PR nightmare that Beijing wants to camouflage.
The link between China’s woes and your portfolio is the U.S. dollar
The Chinese yuan just sank to a nine-month low in the wake of China’s unexpected rate cut.
But remember, when we’re talking currencies, “strength” and “weakness” is always relative to the other variable in the equation. When we’re comparing the yuan to the dollar, that “other variable” is obviously the dollar. So, a weakening yuan is the same thing is a strengthening greenback. And as of yesterday, the yuan had lost almost 3% to the dollar here in August.
But this dollar strength has been extending beyond the yuan in recent weeks. To illustrate, let’s turn to the U.S. Dollar Index, which compares the dollar to a basket of six foreign currencies: the Euro, Swiss franc, Japanese yen, Canadian dollar, British pound, and Swedish krona.
In the last month, the Dollar Index has climbed nearly 4% – that’s a big move for a currency in such a short period.
Now, with this context, let’s now turn to the more relevant question…
Why does China’s economic problem matter to you and your stocks?
The relationship between the dollar and your portfolio
In general, stocks don’t like a strong dollar because it creates a major currency conversion headwind for companies that do international business. All those foreign sales revenues become worth less when converted back into strong U.S dollars.
Below, we look at the U.S. Dollar Index relative to the S&P over the last two years.
You’re going to see an obvious inverse correlation. As the dollar strengthens (in green), the S&P falls (in black), and vice versa.
Through the eyes of a currency trader, it’s no wonder why the S&P has been stumbling in recent weeks – after months of weakness, the dollar is climbing again.
Here’s the Dollar Index (in green) and the S&P (in black) since June to drive home the recent ebbs and flows.
Bottom line: Keep your eyes on China, the yuan, and the U. S. Dollar Index. The greenback’s strength (or weakness) as we move into the fall and holiday season will have a significant impact on your stocks.
One last China note before we move on…
Forgetting the yuan/dollar and just zeroing in on the Chinese economy, check your portfolio for heavy exposure to China. As its economy continues to suffer, it will hurt the multinationals that are heavily exposed to Chinese revenues.
I’m looking at Apple, Tesla, and Caterpillar. Even Nike and Starbucks have significant exposure to Chinese consumers.
And don’t forget about semiconductors – Qualcomm has 67% exposure rate to China, 22% of Nvidia’s revenues came from China last year, and Intel has about 44% revenue exposure.
Be aware of what’s happening and make sure you’re comfortable with your positioning.
Shifting gears, what might changing sentiment mean for stocks in the back half of the year?
One of Warren Buffett’s most-referenced quotes is to be “fearful when others are greedy and greedy when others are fearful.” If we can get beyond the quote’s overuse, its core message is powerful.
The reality is that most people are bad investors. Year-after-year, the studies confirm this, revealing that the average investor woefully underperforms the indexes.
Emotions are to blame. When the markets have been down (presenting more attractive entry prices), we’re usually too scared to take advantage. Meanwhile, when the markets have been surging (presenting less attractive entry prices), our greed/FOMO often wins the day, and we’re happy to plow money into the market at elevated prices.
We tend to sell at the wrong times too (when prices are falling) due to fear. Or we simply refuse to sell a tumbling stock, holding onto our losers too long.
Obviously, “buying high” and “selling low” (or not selling losing stocks) is a recipe for lackluster returns.
To be fair, it’s not much better for professional money managers. A recent S&P Indices Versus Active (SPIVA) scorecard found that 79% of fund managers underperformed their respective benchmarks in 2022.
Clearly, Buffett’s advice to act opposite the prevailing market sentiment represents wisdom.
So, what’s the herd doing today?
Let’s start with retail investors.
From The Wall Street Journal last week:
Individual investors rushed to buy the broad stock market this past week.
Net retail purchases of the SPDR S&P 500 exchange-traded fund surpassed $1.1 billion in the five trading sessions ended Thursday, according to Vanda Research. That marks three straight weeks in which the ETF tracking the S&P 500 has topped the list of securities with the most net buying from individual investors.
As far as individual stocks/ETFs, the ones receiving the most flows are Tesla, Apple, and Nvidia (these names should sound familiar as each is massively exposed to revenues from China).
But retail investor flows have been picking up all year. For example, back in July, retail investors bought nearly $7 billion of equities in a single week. That nearly topped the 2016 record for the largest weekly retail investor inflows to stocks.
What about professional money managers?
Here’s CNBC:
The August BofA Global Fund Manager Survey showed that market professionals have reduced their cash allocations to a 21-month low and are increasingly expecting the economy to weather its various challenges to avoid a recession.
That follows a general feel of pessimism in the air that, in a contrarian sense, helped fuel a rally that has boosted the S&P 500 more than 16% this year.
“Bear positioning strong tailwind for risk assets in [the first half of the year] … not the case in [the second half of the year],” Hartnett wrote in a summary of the closely watched survey.
Here are a few data points reflecting this sentiment shift:
- Cash allocations have fallen beneath 5%. Historically, cash positions greater than 5% have represented a contrarian buy signal.
- 42% of survey respondents now say a recession is “unlikely,” compared with just 10% in November 2022.
- 81% of investors expect softer inflation with lower global prices over the next year, resulting in lower interest rates.
- Optimism about corporate earnings has hit its highest mark since February 2022
Back to CNBC:
In sum, Hartnett said fund manager sentiment is at its “least bearish” level since February 2022, in the early days of a market slump that would take the S&P 500 down nearly 20% for the full year.
Allocation to stocks is the least underweight as a share of portfolios since April 2022 and up 13 percentage points from July.
To be clear, this does not mean “get out of the market.”
Growing optimism and investor bullishness are great news – to a point. Because of this, regular Digest readers know that we’ve been encouraging readers to trade this bullishness higher for as long as it’s here, while being ready to follow stop-losses if market conditions change. That’s still our position today.
But be careful about too much bullishness and its contrarian implications looking forward.
Before we wrap up, one final note about the Fed, interest rates, and uncertainty
As you know, rates have headed higher consistently for months now. While that’s presented challenges for the economy, the consistency of the Fed’s actions has helped the market in one sense – it’s avoided massive surprises.
In the long-term, what drives stock prices are earnings. But in the short-term, what drives stock prices are surprises to expectations – whether those expectations are about quarterly revenues, market share, a surprise step-down from a CEO, you name it.
Today, we’re moving out of an environment of certainty (the Fed will hike rates) into a foggy unknown…
Will we have more rate hikes? If so, how many? If not, how long will the Fed hold rates at today’s level? How quickly will rates fall after that first rate cut? If inflation turns north again next year, will the Fed go back to hikes?
And whereas we’ve had a unified Fed in its voting in recent quarters, that will be changing, which will add to the uncertain climate.
From Bloomberg:
Policymakers are not unified on what their immediate steps should be, with some such as Philadelphia Fed President Patrick Harker saying officials can hold rates where they are “for a while” and others, including Fed Governor Michelle Bowman, saying more increases will be needed.
“Are we done raising rates? I’m not ready to say that we’re done,” Minneapolis Fed President Neel Kashkari said Tuesday.
“But I’m seeing positive signs that say, hey, we may be on our way — we can take a little bit more time to see, get some more data and before we decide whether we need to do more.”
Unfortunately, this new environment of uncertainty creates conditions ripe for disappointed investor expectations.
Remember, the latest Dot Plot from the Fed (from June) shows that Fed members project 2024 rates will come in between 3.75% and 6%.
That’s a huge variance.
Meanwhile, a Bloomberg survey of 45 economists shows that more than one-quarter of participants sees a rate-cut coming in January though the median expectation is that a cut won’t come until March.
More variance.
Bottom line: We no longer really know what’s coming…which means what’s probably coming is heightened volatility.
So, keep riding this bull, but mind your stop-losses and maintain your investing discipline.
Have a good evening,
Jeff Remsburg
