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The yuan depreciated by 3.87% against the US dollar in the year through mid-December.  A decline of a similar magnitude (4%-5%) in 2016 would not be surprising.  It would still likely translate into some appreciation on a trade-weighted basis.

In any event, a country with a large current account surplus would be expected to export its savings.  For many years, China also experienced capital inflows.  The currency was not allowed to appreciate as much as these forces would have suggested necessary. 

Now China is experiencing capital outflows. That is a significant factor that has changed.  US officials have long harangued Chinese officials to operationalize their declaratory policies of letting market mechanisms drive the exchange rate.  US officials have argued against the practices that led Chinese officials to hold so many (over $1 trillion) Treasuries.

It may be well and good that China now sees these actions are no longer in its self-interest and ceases.  However, and here is where the long-game comes in, China should not use this as a pretense to devalue, and then re-link to the dollar when the greenback’s cycle turns.  In the short-run, however, if the yuan appears to be more market driven and the market takes it a bit lower, we do not anticipate loud voices of objections.  That said, the election year in the US means that a greater news cycle risks.

Commodities and Emerging Markets

• The price of energy has far-reaching economic impact.   

• Although there is the risk of a weather shock or a geopolitical disruption in supply, the base case is for oil output to increase over demand in the first half of 2016.

• Many emerging market economies have been hit by a painful negative terms of trade shock: the prices of their products are falling faster than imports and global investors are pulling funds.   

We anticipate that the turn of the calendar will not alleviate the pressure that has bedeviled commodity producers and many emerging market economies.  The slow, mostly domestic driven activity of the high-income countries, and notably the transition in China, dampens demand growth.

High fixed cost producers discover powerful incentives to produce at a loss even if it weighs on prices further.  When prices are high, countries do not recognize the incentives to diversify away from their reliance on commodities. When prices are low, they cannot afford to, and this is how the cycle plays out, again.

The rising commodity prices in the 2005-2008 period provided, with some lag, producers incentives to boost output.  Similarly, the drop in prices will, with some lag, force a rationalization of supply through failures, combinations that destroy inefficient capacity, and spur productivity-enhancing, capital-saving technological advances.

The price of energy has far-reaching economic impact.  Petrol and natural gas products are a key cost of agribusiness, including fertilizers and pesticides.  It is important in manufacturing and transportation.  The decline in gasoline prices has helped boost consumers’ purchasing power in the US, Europe, and Japan.  The drop in energy prices provided economic support in some sectors, even as it weakened energy sector earnings, slashed investment, and undermined share performance. Benchmarks that exclude the energy sector are being developed and will likely to begin to be adopted in 2016. 

The decline in non-OPEC output in the coming months, half of which may come from the US, will likely be offset by increased Iranian and Libyan output.  By its reckoning, OPEC output in November was about 900k barrels a day more than it estimates 2016 demand for its product.

Although there is the risk of a weather shock or a geopolitical disruption in supply, the base case is for oil output to increase over demand in the first half of 2016.  Inventory levels may grow relative to seasonal averages.  Downward pressure is likely to continue.   The charts warn that the price of light sweet crude oil could drop into the $20-$30 a barrel region.  This could force a more rapid industry restructuring and make for a different OPEC meeting a year from now.

Many emerging market economies have been hit by painful negative terms of trade shock.  The price of their products (commodities) has fallen faster than what is typically imported (manufactured goods and capital equipment).  At the same time, global investors generally appear to be pulling funds from the emerging markets as an asset class.  Additional pressure is coming from the unwinding of the currency mismatch that many emerging market countries and companies took on by borrowing cheap dollars in the past.

These are significant economic challenges. Even with strong, decisive and responsive leadership, the waters are difficult to navigate.  Weak, ineffective, or incompetent and corrupt leadership exacerbate the economic challenges.  It accelerates capital flight and aggravates both inflation and recession, which in turn leaves officials choices among poor alternatives.  Investors watch macroeconomic indicators closely.  We note that especially in the current environment, political considerations also warrant close monitoring. 

Marc Chandler
Global head of currency strategy at BBH
Marc to Market

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