Currency looms larger for investors after Chinese devaluation

Emerging market currencies have collapsed this year, led by the Brazilian Real, down over 20per cent. Currencies in a range of other nations – including South Africa, Turkey and Malaysia are not far behind. They are all part of a bigger pattern, encouraged by Japan’s attempt to stimulate by printing money and letting the Yen fall. Few Asian nations have productivity growth that will allow them to remain competitive while this continues. A spiral of devaluation is the inevitable result. Now it is China’s turn to put pressure on its neighbours, as it manages down the Yuan from an over-valued level.

Many British and European companies have significant divisions in China and other emerging markets. Luxury goods, spirits, cars and consumer staples are all in demand in China. But Scotland’s whisky producers are already reeling from a crack-down on luxury goods in China. Now they will find their drinks look more expensive in that market. Each country that allows its currency to fall is trying to capture a bit more of scarce global growth, as well as engineer a rebalancing from consumption to exports. For a time, it may help a domestic economy to do this, and its stockmarket can perform well. But without addressing the underlying problems - such as competitiveness, productivity or domestic demand - it is a race to the bottom.

China has signalled not just its re-entry into the battle for growth, but that global deflation remains a risk. Already, the renewed fall in the oil price over the summer has cut inflation in the US. Along with falling commodity prices, this will also feed into the UK. While the Bank of England emphasises core inflation, excluding energy and food, overall deflationary pressures remain.

On the other side of the devaluations are a few countries with strong currencies; notably the US, UK and Switzerland. Germany, too, is undergoing an internal revaluation as its own economic strength and productivity put stress on the euro. Germany’s inflation is an alternative to the austerity and wage cuts that would otherwise be needed in Europe’s periphery.

It is the strength of the pound that has been the most surprising, perhaps. For investors, that puts a premium on the domestic growth most often found in medium-sized businesses in the consumer, finance, support services and housebuilding sectors. At the same time it brings in deflationary pressures, cutting the price of imports. This should be recognised by the Bank of England, by delaying interest rate rises until next year. The strong currency trend is a positive for the UK, particularly when its government borrowing remains high.

Investors should view the devaluations as a sign of distress. We can expect more from emerging markets, some, like China, with active government encouragement. There is a political risk in many emerging nations if their current regimes cannot deliver growth and improving living standards.

The eurozone is one of the few areas where some reform is underway to make sense of the currency policy. Others are simply not in control of their currencies, and international investors are voting with their feet. Investors should consider carefully whether a cheap currency is enough to make a stockmarket attractive. Japan has shown that devaluation by itself does not solve problems.

This year’s devaluations, combined with collapsing commodity and energy prices, point to deflation risk in the global economy. Bonds and dollar-based investments are ways of recognising this in portfolios. But investors should also note the potential for profit warnings from companies exposed to emerging markets.

Events in China should trigger a broader review of investment strategy.

Colin McLean is managing director, SVM Asset Management