Volatility across most asset classes remains tame, but currency volatility has been rising steadily since the U.S. election (see chart). This is notable, because it has often been a reliable precursor of a jump in equity market volatility. The MSCI All-Country World Index (ACWI) and currency volatility are joined at the hip, reflecting the impact of currency swings on policy decisions and corporate competiveness/profits.
Trade wars and protectionism rank high in investors’ worry list, but all this is best encapsulated under currency wars.
Risk is the fifth “R” of our “R” theme for 2017, and a potential further devaluation of the Chinese renminbi is one of the most important risks to monitor for the year. While stealthy yuan devaluation dominated 2016, the specter of a free floating Chinese currency may take center stage this year. This is the single biggest market risk, as the destabilizing global ramifications from such a move will take time to digest.
Why would the Chinese opt to shock the currency world? Free floating the yuan would send a retaliatory message to President Trump not to embark on a full-blown trade war, which is in no country’s best interest. Such a move would not only stem the outflows (anecdotes of Chinese moving renminbi – and not U.S. dollars per se – out of the country are mushrooming), but it would also stem the depletion of FX reserves.
Until the end of last year, the renminbi had been positively correlated with the MSCI ACWI. Our concern is that this correlation will be reestablished once the post-U.S. election sugar high has been burned off. Any meaningful Chinese currency devaluation could spell trouble for stocks: as a reminder, a 3.3% percent devaluation in August of 2015 caused a knee-jerk drop of at least 10% in global equity bourses.
This is a tail risk we are closely monitoring, and thus this week we are compelled to de-risk the portfolio and book profits in a deep cyclical sector.