China and the Wild Ride in Markets: What We Learned This Week

China and the Wild Ride in Markets: What We Learned This Week
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China and the Wild Ride in Markets: What We Learned This Week

Almost all market participants were shocked by the headline on Monday night that Chinese authorities weakened the reference rate for the yuan by a record 1.9%. Some initially thought it was a mistake. All scrambled to understand the motivations and the implications.

There was a loud chorus of concern that the policy shift was an overt movement back in the direction of a mercantilist approach to managing the economy, and fears of exporting deflation to the world were pronounced in the initial selloff in global equities and rally in U.S. Treasuries and other high quality sovereign bonds.

The IMF, on the other hand, applauded China’s new approach as a shift in the correct direction of allowing market forces to play a greater role in establishing the value of the currency. The IMF considers this a necessary step in the direction of allowing the yuan to enter the basket of official reserve currencies.

In the end, the Chinese currency depreciated by about 4.5% on the week.

But after the initial volatility, how did the yuan’s new regime affect other markets? The frank answer as of a few days later is “Not much.” Friday morning, Treasuries were mostly unchanged on the week, as were U.S. equities.

China’s move this week reinforces several of PIMCO’s key investment themes over the cyclical horizon:

  • First, we expect ongoing diverging trends in official policy actions as countries grapple with the correct policy mix to manage domestic economic conditions.
  • Second, as policy trends diverge, we expect increasing market volatility.
  • Third, we expect volatility will be further increased by diminished liquidity across most financial markets, causing wider price swings than perhaps are justified by fundamental developments.

In this more volatile market environment, nimble investors with a framework for valuation and an ability to see through the extreme views and position portfolios appropriately stand to benefit.

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