The recent report from the Department of Commerce revealed that the U.S. gross domestic product (GDP) expanded at a 2.1 percent annual rate in the third quarter, surpassing the previously reported 1.5 percent. This adjustment was primarily due to a higher-than-expected private inventory investment. However, this growth is still a notable drop from the 3.9 percent increase seen in the second quarter.
Of particular concern is the decline in corporate profits. Profits from current production fell by $22.7 billion in the third quarter, following a $70.4 billion increase in the previous quarter.
According to Reuters, profits were down 8.1 percent compared to a year ago, marking the largest decline since the last quarter of 2008. This drop, reminiscent of the economic weakness during the Great Recession, is certainly not what business leaders are aiming for. Moreover, it suggests that the strength of the economy may not be as robust as policymakers would like the public to believe.
The rising dollar has been widely blamed for the downturn in corporate profits. A stronger dollar diminishes the competitiveness of U.S. firms on the global stage and further aggravates the country’s trade imbalance.
This reduction in profits can create a ripple effect, reducing future earnings and negatively impacting stock prices. With less net revenue, businesses have fewer resources for investments and share buybacks, a strategy used by management to enhance earnings per share.
Marriage of Convenience Headed for Divorce
Amid these challenges, U.S. corporations shouldn’t expect much assistance from the Federal Reserve. In the ongoing global competition to devalue currencies, the Fed is lagging behind its counterparts at the European Central Bank and the Bank of Japan. Even China’s yuan, which is loosely pegged to the dollar, continues to face gradual devaluation by the People’s Bank of China.
In contrast, after maintaining a zero-interest rate policy for seven years, the Federal Reserve is likely to increase the federal funds rate by a quarter percent at the next Federal Open Market Committee meeting. The dollar has been strengthening in anticipation of this move, but there may be unexpected surprises ahead.
Analysts at Bank of America Merrill Lynch predict that the yuan-dollar exchange rate could drop by another 10 percent over the next year. Their outlook highlights some key concerns:
“The question is whether China can cope with rising U.S. interest rates and a stronger dollar, given the semi USD/RMB peg and its increasingly open capital account (which comes at a cost to China’s monetary independence). We are skeptical. This is why we think the USD/RMB peg—a marriage of convenience that has anchored global growth for the past 15 years—is likely facing a split, and we believe the yuan’s devaluation on August 11 was a small step in this direction.
We see the yuan potentially declining by up to 10 percent against the dollar in 2016, which will significantly influence the investment landscape in rates and currencies.”
The economic fluctuations of the 21st century have intensified due to the complex relationship between trade and managed exchange rates between China and the U.S. What initially appeared to be a harmless agreement has proven to be flawed, hinging on the unrealistic assumption that excessive credit growth could last indefinitely while the U.S. and China remained insulated from global dynamics.
Significant Yuan Devaluation Imminent
Over the past two decades, the U.S. Federal Reserve has maintained artificially low interest rates to stimulate economic growth. American consumers have taken advantage of this cheap credit, purchasing various goods—such as novelty items made in China. In response, rather than allowing the yuan to appreciate against the dollar, the People’s Bank of China printed additional yuan equivalent to the dollars received through trade, reinvesting them into U.S. Treasuries and thus supporting the dollar.
This arrangement kept Chinese products affordable in the U.S. and safeguarded China’s manufacturing sector. However, it also led to extensive trade deficits for the U.S. and significant malinvestment and inflation in China.
Currently, with U.S. port imports stalling, a slowdown in the Chinese economy, and a strengthening dollar, the yuan’s pegged value is no longer advantageous for China. It has become a liability as Ben Bernanke’s global savings glut has evaporated.
The robust dollar has significantly hindered China’s export model, especially toward Europe. Furthermore, the considerable investment influx into China, attracted by its thriving export model, is rapidly exiting the country.
Future developments are uncertain; a 10 percent devaluation of the yuan might be too conservative, with the possibility of a 50 percent decline within the year. Such extreme scenarios can emerge without a stable monetary supply.
Ironically, just yesterday, the International Monetary Fund approved the yuan’s inclusion in its Special Drawing Rights currency basket. Starting on October 1, 2016, the yuan will join the U.S. dollar, euro, Japanese yen, and British pound within the IMF’s SDR.
In theory, this should increase demand for the yuan, signaling a bullish trend for the currency in the long run. However, the current economic landscape is heavily skewed. Deflationary pressures from China’s slowing economy continue to mount against the yuan. Hence, a significant devaluation in the near future appears increasingly likely.
Sincerely,
MN Gordon
for Economic Prism
Return from Significant Yuan Devaluation Imminent to Economic Prism
