Financial markets are subject to optical illusions: Stare at anything long enough, and its appearance changes. And the results of that are not always the ones for which we hoped.
Staring at the Chinese yuan (CNY) has yielded just these distortions for many. However, the right lenses, ones designed to view currency impacts on specific stock sectors, can refine that view to the point where a well-reasoned trade emerges.
Friday's speculation that
China will widen its currency's band is the kind of optical illusion that is so problematic. Worse, a large number of manufacturers and the politicians who love them have become convinced by all their looking at the current account deficit that if only the CNY, which has been pegged near 8.277 to the dollar, were allowed to trade freely, it would zoom higher.
Left unsaid is the presumption that this would be a good thing for the U.S. Why I should celebrate higher prices for imported goods and a lower capital surplus is unclear, and this does not even begin to address the gun-to-head logic of recent threats to impose a 27.5% tariff on imports from China.
The presumption that a stronger CNY will by itself correct a trade imbalance is a bit of a stretch. It takes years of significant currency appreciation for an exporter to lose market share. The Japanese yen buys 2.7 times as many dollars as it did in 1973, but Japan's share of exports to the U.S. did not decline until NAFTA made Mexico a significant exporter and until China began to emerge from its isolation.
What will happen if and when China releases the peg is unknowable; who among us predicted that the response to the euro's introduction in January 1999 would be three years of unmitigated selling? China has been flooded with speculative capital waiting for a revaluation, and this capital could jam the exits when it is allowed to leave. We tend to forget in our new view of China that it is still the
of China, and people's republics of anything tend to have their own views of property rights. This is not a warm and fuzzy home for your money.
Total Import Weights for U.S. Dollar
Source: Federal Reserve
How many times would the CNY have to appreciate before China's advantages of labor cost, lack of environmental, health and safety protections and newer capital equipment stock disappear? We are not talking about a 27.5% increase, as proposed for the tariff. We are talking about a several hundred percentage-point increase, and that simply will not be permitted by the Chinese authorities.
An Adjustment Play Today
Two global economic imbalances resulting from the CNY peg have been an appreciation of the euro against the dollar and a manic attempt by the Bank of Japan to suppress the yen's rise against the dollar by buying U.S. Treasuries.
The cross-rate, or direct exchange rate without going through a dollar intermediary, between the yen and the euro weakened between late 2000 and mid-2003, and it now appears ready to move the other way. This especially will be the case should the CNY be allowed to float and if it moves higher as a result.
End of a Trend?
Source: Howard Simons
Which industry groups in the U.S. equity market would benefit from a yen/euro appreciation? To answer this question, I have employed a methodology first introduced here
in February for isolating how much a stock group's performance relative to the
can be attributed to a given factor. Here, I am looking at the related factors of a stronger yen and a weaker euro.
Source: Howard Simons
There is no overlap between the beneficiaries of a stronger yen, which are listed from paper products to gold in the above table's left column, and the beneficiaries of a weaker euro, which are listed from employment services to electrical components and equipment. But you could assemble a long-only portfolio of stocks from both lists and catch the tailwind of the long yen/short euro trade.
Making the Alpha Bet
Let's narrow the search by employing a methodology introduced here
last March, the systematic search for expected over- or underperformance, or alpha. The statistically significant alphas for various industry groups over the past 30 trading days are depicted below; the heights of the bars indicate the variability of these alphas. The green diamonds on the bottom of the bars indicate a positive impact from a stronger yen. The green arrows below the bars indicate a positive impact from a weaker euro. Conversely, the red diamonds and arrows indicate negative impacts from either a stronger yen or a weaker euro. Whew.
Industry Groups With Statistically Significant Alpha
Source: Howard Simons
Four groups, marked with gray boxes, have offsetting impacts: biotech, specialized finance, drug retailers and steel. The remaining marked bars give you the raw material with which to work. If you fancy yourself a value investor, the beaten-down groups aided by the weaker euro include semiconductor equipment, electrical manufacturing, broadcast and cable TV, and data processing and outsourcing. Groups indicated as overvalued in a falling-euro environment include electrical utilities, integrated oil and gas, oil and gas drilling, managed health care, oil and gas exploration, and oil and gas refining.
We can summarize the trades for a weaker euro environment as long tech and short energy.
No momentum-style trades are indicated. This is not surprising, given the prominence of the short yen/long euro trade up to this point.
Is this a lot of work to get from the macroeconomic inkling of a stronger yen upon revaluation and an intermediate yen/euro trade to an industry group-specific set of trades in the U.S.? Yes, but if it's worth having, it's worth working for.
Howard L. Simons is president of Simons Research, a strategist for Bianco Research, a trading consultant and the author of
The Dynamic Option Selection System. Under no circumstances does the information in this column represent a recommendation to buy or sell securities. While Simons cannot provide investment advice or recommendations, he invites you to send your feedback to
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