Time to hit the panic button?

On the day that the Chinese New Year begins, Schroders' chief economist Keith Wade says that the biggest 'known unknown' for the global economy is a potential devaluation of the Chinese Yuan

Time to hit the panic button?

Two factors have been blamed for the rout in markets seen this year so far. The first is the further fall in the oil price which appears to have led global equity markets down over the past year. We believe concerns are overdone and maintain that lower oil prices generally lead to strong growth (although with around an 18 month lag).

Weaker yuan, weaker equities

The second factor is the depreciating Chinese yuan. We do not see a strong case for the authorities to devalue the currency and are encouraged that the yuan has been stable since 7 January. In our view, it is likely that the authorities will have to reintroduce capital controls to maintain currency stability as domestic rate rises are out of the question.

Against this backdrop, we see our exchange rate wars scenario (where China devalues by 20%, triggering a reaction from others), as increasingly likely. The Bank of Japan’s introduction of negative interest rates in January can be seen as a response to the sharp appreciation of the trade-weighted yen since the beginning of the year.

US recession risk?

Fears about US growth have also been driving risk assets lower. We believe these concerns are overdone. Firstly, the oil price will boost consumer spending; secondly, fiscal policy will add 0.5% to US GDP this year through increased government expenditure and thirdly the corporate sector is not unduly extended while household balance sheets have significantly improved.

Much of the recent weakness in the US has been due to the inventory cycle and, as long as final sales hold up as we expect through the consumer, growth should firm in the current quarter. Nonetheless, the likelihood of the US Federal Reserve raising rates in March has been considerably diminished.

Our analysis suggests that some of the gloom about the world economy has been overplayed, particularly as regards the oil price. Have markets then become too bearish? The biggest unknown is what will happen to the yuan and whether we will see a more significant devaluation.

If there is some stability in the yuan, soothing comments from the Fed and better growth figures in coming months, the backdrop for markets would brighten substantially.

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