There has been a lot of action in the stock and the bond market recently. In this week’s blog post, I will talk about my take on the current events. Let me briefly go over these current events: United States and China are in a trade war, where US is imposing tariffs on Chinese goods in order to make the prices of US domestic goods more competitive to the prices of imported Chinese goods. While this trade war is going on, the Federal Reserve is noticing slowing growth in China and Europe. On July 31, 2019, the Federal Reserve cuts the interest rate for the first time since 2008 crisis. On August 8, 2019, China’s central bank set the official reference for Chinese currency at 7.0205 yuan per dollar, which has been the weakest level since April 21, 2008. What does all of this mean? Let’s talk about it.
United States and China are in a trade war. When United States imposes tariffs on Chinese goods, the cost of those Chinese products goes up for end consumers like you and me. This means that the “Made in China” products would potentially just be as expensive as “Made in USA” products. In other words, China would lose its competitive advantage of producing cheap products. China’s economy is based on manufacturing inexpensive products, and if they lose the biggest consumer (United States) of its products, it would definitely slow down China’s economic growth. Thousands, if not millions, of Chinese workers could lose their jobs if United States stops consuming Chinese products.
Observing a global economic slowdown, the Federal Reserve cut the interest rates by 0.25% as a precautionary measure. Although this rate cut weakens the US Dollar, lowering interest rate stimulates economic growth. How does it stimulate economic growth? Well, with lower interest rates, the financing costs are reduced, which encourages US companies to borrow and invest. For instance, a company that wants to build a factory is more likely to apply for a $500 million loan at 2% interest rate rather than a 2.25% interest rate. A 0.25% change in interest rate can drastically change a company’s interest payments when the borrowed principal is large.
Either due to concerns over China’s slowing economic growth or due to the tariffs imposed by the United States on Chinese goods, China’s central bank devalued China’s currency. By devaluing its currency, China ensures that the products it exports remain cheap. For example, assume that it costs China 5 Yuans to manufacture a pen. Also, assume that 1 US dollar equals 5 Chinese Yuan. Before the tariffs were imposed, that Chinese pen would technically cost you $1. Assume that the cost of this pen is going to be affected by the 20% tariff. So, after the 20% tariff, you and I would pay $1.20 (i.e. $1 plus 20% of $1) for this pen. Now, imagine China’s central bank coming around and saying that 1 US dollar is going to equal 10 Chinese Yuan. It still costs China 5 Yuan to manufacture that pen. However, after the devaluation, 5 Yuan only equates to $0.50. So, after the 20% tariff, you and I would pay $0.60 (i.e. $0.50 plus 20% of $0.50). As you can notice, by devaluing its currency, China would not be affected by any tariffs. Moreover, China could see more growth because its products would be cheaper for the rest of the world that is not imposing additional tariffs like United States is. The biggest downside to devaluing a currency is that it causes inflation. Inflation might not be evident right away, but after a certain time, inflation would be obvious. For example, image you are a worker in China who loves to eat roast beef sandwich everyday. The beef that goes in your sandwich was imported from United States. Before the devaluation, that beef in your sandwich only costed 5 yuan (i.e. $1). However after the devaluation, the beef in your sandwich would now cost you 10 yuan (i.e. $1). Notice that it still costs $1, but that roast beef sandwich is going to cost you 5 additional yuans. Similar to increased cost of beef, China would see the costs of all its imports rise. So, in the long run, currency devaluation causes inflation. However, in the short run, it does help China grow its manufacturing economy.
What does all this mean to you as an investor? You can expect lower profits from US companies that sell products to China; after devaluation, the costs of products that China imports would rise, which means the demand for those products would drop (Demand Curve in Economics). US domestic companies might be outperforming the market at this time, assuming that the stocks have good fundamentals and are undervalued.
Hope you learned a little and found this blog post helpful. We talked about the Trade War, Federal Reserve, China, Interest Rates, Currencies, And More. We saw the effects of devaluation and increasing interest rates on economies. As always, you can sign up for our mailing list here. Like us on our Facebook page here. Thank you!
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Superior North LLC’s content is for educational purposes only. The calculators, videos, recommendations, and general investment ideas are not to be actioned with real money. Vyom Joshi is not a professional money manager or a financial advisor. Contact a professional and certified financial advisor before making any financial decisions.