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Financial Market Issues Explained – In Plain English

 

Shanghai_Pudong_Jan_2_2014

Financial Market Issues Explained – In Plain English

By Jean Rosenbaum, CFA and Portfolio Manager, Hotaling Investment Management, LLC

 

Why have the financial markets sold off so sharply recently? The Yuan devaluation seemed small.

The recent sharp decline in the S&P 500 was sparked by the devaluation of the Chinese Yuan. While the amount of the move in percentage terms has not been large, it has clearly destabilized some financial strategies, causing a broad sell off. Many investors had been confident the Yuan would remain stable or appreciate, but it has done the opposite!

The devaluation of the Yuan is the symptom of a bigger problem that began with the end of the Global Financial Crisis (GFC). To deal with the problems of the GFC, central banks, beginning with the Fed, lowered interest rates which caused a weakening of the currency. The low interest rates in the developed world, made the higher rates in the Emerging Markets (Malaysia, Indonesia, Turkey, Brazil, etc.) much more attractive, encouraging capital to move into the Emerging Markets. The influx of capital fueled the growth of EM, but has also left them with a big build up in external debt, denominated in foreign currency. 

Debt denominated in another currency is only a problem when the local currency weakens relative to the currency in which the debt is denominated. Unfortunately, this is the situation that many Emerging Markets now find themselves in as their local currencies have depreciated relative to the value of the debt which is priced in U.S. dollars, Euros or Yen. 

As the Chinese have watched their customers’ currencies weaken, their economy has suffered as well. To remain competitive and to move to make the Yuan more freely tradeable, the Chinese officials have weakened the currency. It is possible the currency weakens further if the GDP growth does not reach their targets.

Our main focus is investing in the stocks of U.S. companies.  Our expectations hinge on factors much closer to home than China.  Just the same, the global economy today influences investors who also invest in U.S. stocks.  When trouble brews, it’s common for various asset classes to begin to behave similarly, until the smoke begins to clear.