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What's your investment strategy post the Chinese devaluation?

Aug 18, 2015

In this issue:
» Why are small cap stocks soaring?
» Is India breaking away from other emerging markets?
» ...and more!

Nothing got more headlines last week than China's sudden devaluation of the yuan. This latest currency war cannonball from the dragon nation can do some serious damage. But China's policymakers had few options. They had to find a way to pull their economy out of its current weakness, and nothing gets the export machine moving better than a good devaluation.

Global reaction was sharp. Some experts went as far to call it the spark to set alight a worldwide recession.

If this is all Greek and Latin to you, let us be clear: The investment climate has never been this challenging. What's more likely, inflation or deflation? Even we aren't quite sure.

Governments across the developed world support inflation for the same reason a corporate CEO would support an increase in the price of his company's goods or services - especially if the company has a large amount of debt on its balance sheet.

Price increases would mean more profit, which the CEO could use to pay down the debt before the lenders come knocking.

So imagine if instead of inflation the CEO faced deflation. This would hurt profits and make debt repayment very difficult indeed.

Many governments are in a similar situation as the CEO. They've built a gigantic debt complex over the years, and servicing it gets more difficult every day. They hope for sustainable inflation in their economies because it would mean more tax revenues with which to pay down their debts.

But economic activity on the ground shows all signs of deflation. Just take a look at the GDP growth of most major nations across the world.

And so what we have is battle between the governments' attempts at inflation and their economies resisting with all their deflationary might. Without government and central bank money printing and record low interest rates, we'd probably have had a full-blown depression by now.

Are you starting to see why China devalued its currency?

China's economy is also showing classic signs of deflation. GDP growth slumped to the lowest levels in years. Stocks suffered a massive meltdown. The nation's massive capacities lay idle.

And so to counter this, the government is going all out to try and create some inflation through currency devaluation.

But this move comes with its own set of collateral damages.

When China inflates, it exports deflation to the rest of the world, especially to the US. Yuan devaluation makes the US dollar even stronger. This is bad for US-based companies, as the revenues they earn outside the US will now be lower than before. Further, their products have to compete with Chinese goods that are now even cheaper after the devaluation. This could put US economy in a massive deflationary spiral.

If the Federal Reserve decides to hike interest rates (a highly deflationary move, as you know) in this environment, it could be the proverbial last nail for the US economy. Perhaps the scales are beginning to tilt in favour of deflation.

Is it any wonder that many experts are calling the Chinese devaluation the final warning sign of a big recession?

Given that a recession looks a near certainty now, should investors start building deflation-proof portfolios?

We think not. For the simple reason that there's no guarantee the Fed will raise interest rates. What if it has a change of mind and keeps rates where they are? This would tilt the scales back towards inflation...and potentially avert recession for some time.

The thing is, inflation or deflation, no one knows which way the needle will ultimately swing.

In the end, it's a 50-50 shot either way...but it's next to impossible to predict the exact timing. In view of this, investors who position their portfolios to profit from either inflation or deflation are taking a big risk. The ideal way prepare is with protection for both scenarios. You can do that through exposure to stocks, gold, bonds, and cash.

If inflation is headed our way, gold and good quality stocks with pricing power will hold their value quite well. But if we get deflation, bonds and cash will be king. (Bonds increase in value if interest rates go down. And cash is always precious when other assets around are taking a beating.)

The idea in all this is to analyse carefully, be prepared for both eventualities, and remain quick footed to change allocation if required.

What about you? How are you positioning your portfolio in the wake of the Chinese devaluation? Let us know your comments or share your views in the Equitymaster Club.

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 Chart of the day
In world where developed economies have been beset with structural problems, emerging market economies have been looked upon as a glimmer of hope as far as global growth is concerned. But this was not to be for long, or so it seems. Emerging economies too are finding themselves caught up in a web of different problems. And not surprisingly, their stock markets are getting battered.

As the Financial Times observes in a recent report, the MSCI Emerging Markets Index has fallen to a 4 year low on the back of emerging market funds seeing large outflows. Led mainly by the fear that waning economic growth and slumping currencies will take their stock markets down with them. In fact, outflows from emerging market equity funds continued for a fifth straight week last week, taking the total outflows for the year to almost US$ 32 bn as per the report. Ironically, such outflows are creating a vicious cycle by spurring even more depreciation in their currencies.

Today's chart of the day highlights the effect all this has had by pegging the MSCI indices of various emerging markets. Many are down significantly compared to their levels at the start of year. The overall MSCI Emerging Markets index is down 10% during this time. While the return of the MSCI India index too is nothing to write home about, the absence of negative returns in itself is the biggest positive here it seems.

Emerging markets performance in dollar terms

And while the Indian markets seem to be faring better than its peers, take a closer look and one realizes that there's been a divergence. Smaller listed companies seem to be faring better than their larger peers. For example, while the S&P BSE Midcap and Smallcap indices are down just 2% to 3% from their 52 week highs, the S&P BSE Sensex is down a much larger 7%.

A recent Economic Times article pins down this trend to these companies' performances during the June quarter results season. The smaller companies seem to have reported much stronger earnings growth. As per the article, aggregate profit growth of the BSE's Small-cap index companies that have already announced their results came in at 21% YoY. Led by the falling raw material prices, this it seems was the highest profit growth in the last 8 quarters. In stark contrast, it pegs the aggregate profit growth of the Sensex companies at 1.6% YoY during the quarter.

Thus the stocks of smaller companies may very well have done better due to their seemingly better June quarter showing. But we on our part are inclined to believe that the earnings growth over a period of time as small as just 90 days is hardly any reason to bid up the price of a company or a group of companies. It may very well kick up some speculative activity leading to some stocks doing better than others. But to the buyer of long term values, it is pretty much a non-event.

Though the Indian stock markets started strong today, selling activity across most index heavyweights in the post-noon session dragged the benchmark down into negative territory. At the time of writing, the BSE-Sensex was trading down by around 47 points. Losses were largely seen in metal and realty stocks.

 Today's investing mantra
"In the business world, the rearview mirror is always clearer than the windshield." - Warren Buffett.

This edition of The 5 Minute WrapUp is authored by Rahul Shah (Research Analyst).

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