In an environment characterized by an uncertain Federal Reserve and a declining Chinese yuan, investor concerns have alternated between the fed funds rate and China, but the risks posed by one or the other are most often in a constant state of flux. However, as noted by The Goldman Sachs Group Inc. (NYSE: GS) in its US Weekly Kickstart letter dated June 3, 2016, the markets are likely to be more affected by currency fluctuations in the yuan than by incremental rate increases by the central bank over the remainder of 2016. In this paradigm, the investment bank is calling for companies generating most or all of their revenues in the United States to outperform exporters as the U.S. dollar strengthens against the yuan.
Fed Talk but Little Action
Due to slow growth in the United States and global economies, the Fed has warned of imminent rate increases before changing directions on several occasions, most recently following the June meeting. After months of constant warnings, it is highly likely that the market has already discounted the next rate hike, whether it occurs in July or later in the year. The impact of rate hikes has also been muted by the perception that the Fed has no interest in getting ahead of the market with rate hikes and is instead gauging the strength of the economy by the performance of the market.
Goldman also points out that the Standard & Poor’s 500 Index (S&P 500) has appreciated in every period of rising rates over the last 30 years, with an average annualized gain of 10%. The trend held true again after the rate hike in December 2015, as the S&P 500 gained 2.6% through June 3, 2016.
The Significance of a Declining Yuan
A strengthening U.S. dollar versus the yuan may shift investors’ attentions to companies generating most or all of their revenues and earnings in the United States. Referred to as being domestic-oriented or domestic-facing, dollar-based earnings shield these companies from the effects of declining currencies, which can lead to rising export prices and lower foreign sales. Goldman also notes that, on a historical basis, domestic-facing companies have traded at slightly lower price-to-earnings ratios (P/Es) to U.S. exporters.
As of June 3, 2016, however, the spread in valuations had widened to 7%, because exporters had gained 7.7% year-to-date (YTD), while domestic-facing companies returned 2.1%. In addition to the discounted valuation, companies with a high percentage of sales in the United States are expected to have higher growth rates in revenues and earnings due to the anticipated decline in the yuan. For domestic companies, revenues and earnings are expected to grow at 6 and 8% versus exporters at 2 and 3%, respectively.
Within the category of domestic-facing companies with no foreign sales, which are likely to be the least affected by a declining yuan, there are examples in all 10 sectors of the S&P 500. The largest of these companies include Wells Fargo & Co. (NYSE: WFC) in financials, Verizon Communications Inc. (NYSE: VZ) in telecommunications and Altria Group Inc (NYSE: MO) in consumer staples.
The Yuan and the S&P 500
With exports accounting for approximately 50% of total revenues in the S&P 500, an increasing number of companies can be affected by currency fluctuations, as well as contracting foreign economies. Goldman also cites the pace of the decline of the yuan as an important determinant in the performance of U.S. markets. For example, in 2015, sharp moves in the yuan were followed within weeks by declines in the S&P 500. On the other hand, during the measured pace of the 2% decline of the yuan from the beginning of Q2 2016 through June 3, 2016, the S&P 500 gained approximately 2% and reached its high for the year at 2015.
The Connection of the Yuan and Fed Funds
The importance of the fed funds rate to markets and the economy may be less than that of a declining yuan, but an eventual rate hike could have an indirect effect by adding pressure on the exchange rate of the currency. The yuan is already facing a variety of substantial challenges including the increase of corporate loan defaults, a slowing manufacturing sector and outflows of capital. While a fed rate hike is unlikely to be the primary factor in the continuing decline of the yuan, in an environment that can turn on any event it is not be a surprise that the Fed has been willing to stand pat on rates since December 2015.
