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Chinese Renminbi, The Basics
ETF Securities Currencies – Chinese Renminbi, The Basics
Summary
The liberalisation of currency controls and the growth of the “Dim-sum” bond market have seen the global trade of the hinese Renminbi (RMB) soar in recent years.
The RMB has come into sharp focus since last August, where its sudden depreciation generated a severe market selloff.
The RMB is traded on both onshore and offshore markets and rates between the two can differ.
Capital controls currently in place require the use of Non- Deliverable Forwards (NDFs) to gain exposure to the onshore RMB exchange rate for investors.
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A Brief History
Since the development of the Yuan in 1948, Chinese authorities have maintained strict control over its value, pegging it to the US Dollar at various levels to meet economic objectives1. From 1994, the fixed exchange rate regime saw China accumulate a large trade surplus and considerable foreign exchange reserves (see Figure 1) as the undervaluation of the currency kept international exports artificially competitive.
(click to enlarge) 1 A Yuan is a unit of Chinese currency and is to the Renminbi (RMB) what the Pound is to Sterling, so both terms can be used interchangeably.
Unsurprisingly, this policy was unpopular and generated pressure from its primary trading partners, pressure which in 2005 led to a movement towards a “managed floating” exchange rate regime and a removal of the peg. This gave the currency more flexibility but still allowed for government influence on its overall level.
In more recent years, Chinese authorities have altered course and have progressively removed barriers to the free trade of the RMB. These moves have prompted the growing use of the Yuan in international business, with the RMB recently surpassing the Japanese Yen to become the fourth most popular payment currency globally (SWIFT, 2015). In addition, the proliferation of the “Dim-sum” bond market in 2009, which are bonds issued outside of China denominated in RMB have also helped the internationalisation of the currency. Global bodies like the International Monetary Fund (IMF) have also acknowledged the increasingly “free” use of the RMB and have included the Yuan in the valuation of its coveted Special Drawing Rights (SDR) basket in October of last year.
(click to enlarge)
Many faces of the RMB
The global market for the RMB is somewhat segmented and so is quoted in a number of forms.
The RMB is traded both on the onshore Chinese market and on numerous offshore markets in Hong Kong, London, Singapore and New York. On a daily basis the People’s Bank of China (PBoC), the Chinese Central bank, provides a daily fixing (at 09.15 local time) for the onshore rate (CNY) against the a basket of reference currencies, around which the pair can trade within a ±2% band. This onshore market, despite being somewhat liberalised, is still subject to considerable regulation.
The offshore market rate (CNH) is not subject to as strict controls and is ultimately determined by market forces. While the CNY and CNH rates tend to move in tandem, differences in liquidity and capital restrictions on arbitrage prevent this gap from closing permanently (see Figure 2).
Yuan plunges
On August 11th 2015, the PBoC announced that it would modify the mechanism through which the daily Yuan fixing would take place. In attempt to foster a more “market-driven” process, quotes from onshore primary dealers would be used as inputs into the calculation of the fix on a daily basis. That morning, the USD/CNY fix plunged 1.9% and the next day a further 1.0% in response, the largest absolute one day moves since the peg was removed in 2005.
The sharp declines sparked speculation that Chinese authorities were more concerned about domestic growth than previously anticipated and permitted the depreciation to boost the competitiveness of Chinese exports. The Chinese stock market reaction was sharp; with the Hang Seng Index plunging 3% intraday (see Figure 3). The impact was felt globally, with other major equity indices also falling considerably, only to recoup losses in the subsequent trade.
(click to enlarge)
How to trade the CNY
Due to trading restrictions imposed on the CNY, a liquid market for CNY Non-Deliverable Forwards (NDFs) has blossomed. An NDF is a forward contract that fixes the exchange rate for a currency transaction at some point in the future. At expiry the profit/loss of the underlying contract is calculated and converted into US Dollars and settled.
NDF’s evolved out of the necessity for market participants to hedge exposure to currencies such as the CNY, Taiwan Dollar (TWD) and the Brazilian Real (BRL) all of which are subject to capital controls and cannot be physically delivered. Like FX forwards, the rates at which NDFs price is based on expected future interest rate differentials between the two relevant currencies.
When using NDFs, an investor has to “roll” his/her position prior to expiry in order for the currency exposure to be maintained. “Rolling” involves closing out a near term position before it expires and re-investing in a longer dated forward. Like in other asset classes this process can incur a cost/gain depending on the shape of the forward curve. As mentioned previously, interest rate differentials determine forward FX levels and thus dictate the shape of the curve and the corresponding impact of the roll (see Figure 4).
(click to enlarge)
An alternative to investing through NDF’s directly is to utilise currency exchange traded products (ETPs). Currency ETPs provide a transparent, liquid and freely tradable medium through which to gain access to emerging market currency pairs. Currency ETPs trade like shares and mitigate some of the operational complexities involved in investing in NDFs, although indices are priced from NDF’s.
Prospects for the CNY
Chinese authorities continue to manage the nation’s transition from an export and investment led fast growing economy to a more moderate mature consumer driven model. Recent declines in the PBoC’s FX reserves and intervention in the onshore stock market reflect the government’s desire for stability during this period of change. Therefore the possibility of further monetary intervention remains, which, in the near term which could weigh the RMB.
Important Information
This communication has been issued and approved for the purpose of section 21 of the Financial Services and Markets Act 2000 by ETF Securities (UK) Limited (“ETFS UK”) which is authorised and regulated by the United Kingdom Financial Conduct Authority (the “FCA”).
The information contained in this communication is for your general information only and is neither an offer for sale nor a solicitation of an offer to buy securities. This communication should not be used as the basis for any investment decision. Historical performance is not an indication of future performance and any investments may go down in value.
Market momentum has been shifting recently with a rotation away from large-cap stocks. As more investors look to broaden their exposures, Franklin Templeton’s Dina Ting weighs in with a few considerations for diversification through multifactor ETFs.
In retrospect (and barring any impact from airline outages and the like), the first weekend of August would have been an excellent time for a vacation. Hopefully, you had a few screen-free days focused on a good beach book and spared yourself the anxiety of some wild market swings.
During this time of global market turmoil, Japan’s stock indexes experienced heightened volatility. A surge in the yen—that gave pause over the prospects of Japanese exporters—followed worrisome new US economic data and exacerbated fears. Over just two trading sessions, Japan’s benchmark Nikkei 225 Index dropped 12.4% on Monday, August 5, 2024, before rebounding over 10% the next day.1
Even investors who were blissfully unaware of the selloff drama in real time were probably still experiencing some creeping concerns over portfolio concentration to US technology giants. Judging by Wall Street’s elevated “fear gauge,” the VIX index, you’re in good company if this summer has tested your faith in the Magnificent Seven3 tech darlings.
But before any more panic sets in, consider a few points we’re thinking about this month. Namely, focusing on long-term investment strategy means ignoring the “bobs up and down,” as Warren Buffet puts it. US unemployment is still rather low at 4.3%4 and given that economic activity in the services sector expanded in July,5 we believe an imminent recessionary environment appears unlikely.
Historically, during cooling economic cycles, investors typically favor blue chips, but July’s moderating inflation data boosted sentiment for mid- and small-capitalization stocks. Both the Russell 2000 Index, which rose 10.2%, and the Russell Midcap Index, up 4.7%, outperformed the S&P 500 Index’s 1.2% gain for July.6
Overlooked mid- and small-cap segments
The market rotation away from mega-cap stocks has fueled attention to the often-overlooked, mid-cap segment and led to a preference for interest-rate-sensitive, small-cap stocks following indications from the US Federal Reserve (Fed) over lower borrowing costs to come, possibly in September.
Despite the attractive risk/reward profile of mid caps, which feature more established customer bases and brands than their smaller-cap peers, investors tend to be under-allocated to the segment. To put this in perspective, investments in large-cap mutual funds and exchange-traded funds (ETFs) are about nine times greater than those in mid-cap mutual funds and ETFs.7 US mid-cap stocks (as measured by the S&P MidCap 400 Index) have outperformed their large-cap (as measured by the S&P 500 Index) and small-cap (as measured by the S&P Small Cap 600 Index) counterparts over the past three decades.8 In our analysis, many mid-sized companies hit the so-called “sweet spot” in that they feature a lower risk profile than small caps and faster growth prospects than large caps.
Exposure to mid-caps indexes also offer the added benefit of diversification. At the end of July, technology sector holdings comprised 29% of the Russell 1000 Index compared to just 13% in the Russell Midcap Index.9 And while utility companies were the best performers (+18% total returns) for the mid-cap index, they held the smallest sector weighting within large-cap benchmarks.
Beyond the market-cap criteria, we believe that multifactor strategies can target allocation and pursue stronger risk-adjusted returns for a smoother ride over the long term compared to traditional market-cap-based indexing. In our view, a forward-looking, rules-based index design that analyzes individual stock exposure against a well-vetted mix of factors—quality, value, momentum and low volatility—can serve as a middle ground between active and passive management. The process may provide exposure to high-quality companies at a reasonable price, while also potentially avoiding value traps.
As shown in the table below, quality-tilted and momentum stocks, which tend to show ongoing positive price trends, performed better than the broader market last year. The S&P MidCap 400 Quality Index and the S&P MidCap 400 Momentum Index, returned nearly 30% and 20.3%, respectively, for the year against the 16.4% gain for the overall S&P MidCap 400 Index.10 By comparison, the low volatility factor underperformed the most in 2023.
Exhibit 1: Differentiated Sources of Returns
One-Year Absolute Return by Factors
December 31, 2023
Source: Morningstar as of 12/31/2023.
The case for small caps
July’s broadened stock rally brings into view the market’s small-cap segment. That same month, the Russell 2000 Index of smaller stocks saw its largest outperformance over mega caps in decades, returning more than 10%, while the Nasdaq-100 Index lost 1.6%.11
Currently, at 15.1x forward earnings, the small-cap benchmark is trading at a discount to both its long-term average and the S&P 500’s forward price-earnings ratio of 20.4x.12 We believe that a multifactor approach to small caps, which we consider to be an attractive asset class, should be represented in diversified portfolios.
Stocks with value traits—which emphasize holdings that are inexpensive relative to their fundamentals—have underperformed in recent months and year-to-date through August 8, 2024, not only within the small-cap but also for the mid-cap segment. But zoom out further and we see that the Russell 2000 Value Index has outperformed the Russell 2000 Growth Index over the past 25 years by 1.82% on an annualized basis.13 In our opinion, anchoring quality-tilted stocks, marked by profitable companies with capital efficiency and momentum, together with value and low-volatility factors can hedge against risks.
Year-to-date through August 8, 2024, consumer staples holdings were the top performers for the small-cap index, with such specialty food companies as Vital Farms, Sprouts Farmers and Natural Grocers by Vitamin Cottage leading the way.14 Consumer staples tends to be a safe-haven sector that can outperform during times of uncertainty, such as amid periods of political uncertainty.
Being earlier in their business life cycle, small caps are generally seen to have strong growth prospects, and the segment has appealed to investors this year as a timely investment given anticipated rate cuts. Since smaller companies generally have more borrowing needs, they tend to get a boost when monetary policy eases.
Exhibit 2: Small-Cap Performance After Fed Rate Cuts
Russell 2000 Index Performance After Fed Rate Cuts
June 2001–June 2020
Sources: Bloomberg, Federal Reserve Bank of St. Louis.
We believe that factor diversification can allow for a targeted outcome with a smoother risk/return profile versus market capitalization-based indexes. In addition, holding a multifactor portfolio can also provide the advantage of not attempting to time factor cycles, nor incur costs associated with switching from one product to another. A multifactor methodology allows investors to outsource that task—so your summer beach time can be better spent.
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