China fired the first shot in what could be a global currency war by devaluing their currency -1.9% overnight. That was the biggest drop in more than 20 years. Now the rest of the emerging markets will be pressed to devalue in order to remain competitive.

Market Statistics

This was the biggest one-day drop in the yuan since China ended the dual-currency system in January 1994. The PBOC said this was a one-time adjustment and future changes would be more aligned with supply and demand. They said the yuan exchange rate will now be quoted by market-makers "who will have to consider the prior day's closing spot rate, foreign-exchange demand and supply, as well as changes in major currency rates." This is a major change from the official government fix in a very narrow band. It effectively will allow the value of the yuan to trade on a market value basis.

China is currently suffering from the deepest economic decline since 1990. The government is struggling to maintain a grip on the financial system as the economy crumbles. The recent efforts to shore up the stock market showed they really had no grasp of the magnitude of the problem. Now that ineptitude is on display in the broader market. The yuan declined -1.8% to close at 6.3231 to the dollar in Shanghai.

Over the weekend, China said July exports fell -8.9% and imports declined -8.6%. China maintains the economy is still growing at a 7.0% GDP but the drop in commodity demand as well as those trade numbers above suggests reality is a lot worse.

By reducing the value of their currency, it will make their exports cheaper and increase demand. It also makes imports more expensive and will slow demand. This is the real problem. The emerging markets are very intertwined in the import/export arena. By devaluing the yuan it means South Korea, Taiwan, Singapore, Malaysia, etc will be forced to devalue their currencies to compete with China. Basically China fired the first shot in a currency war and now we could see a race to the bottom as other countries try to remain competitive by weakening their own currencies.

There is a serious worry that Japan will further weaken the yen in order to compete by increasing the $640 billion in annual QE.

Bloomberg Chart Source

In the bigger picture, this will increase deflationary pressures all around the world. This one move will probably not keep the Federal Reserve from hiking rates in September but future rate hikes will depend on the intensity of the currency war at that time and the strength of the dollar.

In addition to the drop in the yuan the Chinese government is expected to lower interest rates again this quarter, which will be the fifth cut over the last year, and lower lender reserve requirements to put more money into circulation.

One factor not getting much play today is the future of the yuan as a global reserve currency. China has been trying to get the yuan accepted by the IMF as a reserve currency equal to the dollar, euro, mark, franc and pound. Getting the yuan accepted by the IMF would be a major gain for China and a blow to the other currencies. Since a large portion of global trade is in goods flowing to and from China it would immediately make the yuan a more accepted currency and reduce the dependence on the dollar and others in world trade.

In order to be accepted by the IMF as a reserve currency the yuan must be "freely usable" and the exchange rate cannot be fixed. The IMF recently told China the yuan had to be more flexible in order to be considered. Apparently, China is moving in that direction with this daily market oriented fixing process. Mohamed El-Erian believes this is a play on getting the yuan accepted as a reserve currency with Special Drawing Rights (SDR with the IMF. Analysts believe the acceptance of the yuan as a SDR reserve currency could see more than $1 trillion flow into yuan denominated assets. That is a huge move since it means $1 trillion would flow out of other reserve currencies like the dollar.

"IF" the yuan is actually going to be allowed to float the direction of that initial float is not likely to be higher. China has kept the yuan artificially high for years. That means a sudden change to a floated currency could see that artificial support eroded over the next few months. It is like a stock that had a major buyer building a position at some specific dollar amount. As long as that buyer continues to buy at that level the stock will remain flat. Once that buyer completes his position the market will take over and shares will be able to seek their own level. China is stepping away from supporting the yuan but it is not likely to be a one-day event. They will probably continue to manage the price by intervening in the currency markets by purchasing the yuan if the market value begins to slip. They cannot keep this up forever but it may prevent any sudden swings over the next few weeks.

However, according to Mark Chandler from Brown Brothers, in the offshore markets the yuan continued to decline overnight by another -2%. Depending on how they fix the price at the open on Wednesday (9:PM tonight) there could be another big decline in the yuan and another ripple effect in emerging market currencies. This yuan news may linger for the rest of the week as the price finds its level in the market.

Not that anyone was watching but there were some positive economics this morning. The Wholesale Trade report for June showed a gain of +0.9% in wholesale inventories. This was well over the estimates for +0.4% and the +0.6% in the May report. Nondurable inventories rose +2.3% while durable goods rose only +0.1%. Durable goods sales declined -1.1% while nondurable sales rose +1.2%. This report could influence a small bump in the Q2 GDP.

The Productivity and Costs report for Q2 showed a rise in hourly output for nonfarm businesses of +1.35% after two quarters of declines. Q1 was revised higher from -3.1% to -1.1% and Q4 declined -2.2%. Compensation per hour rose +1.8%. Manufacturing output per hour rose +2.5% with compensation per hours up only +0.2%.

The NFIB Small Business Survey showed that the optimism index rose from 94.1 to 95.4 for July. Seven of the ten components advanced. This small gain only recovered a minor part of the -4.2 point decline in June. The earnings trends component declined from -17 to -19 and a four-month low. Those expecting the economy to improve rose from -9 to -4 and a slight improvement although still negative. That means a net -4% expect the economy to decline. Hypothetically that would look like 52% expected a decline and 48% expected it to improve. Only the net number is shown.

There are no economic reports of note for Wednesday. The retail sales report for July on Thursday morning is the most important report for the week followed by the PPI on Friday.


The Chinese devaluation crushed dozens of stocks that derive a large portion of their revenue from China. Leading the list with a -$6.20 decline was Dow component Apple (AAPL). That erased 48 points from the Dow and completely obliterated the +$4.25 gain from Monday. YUM Brands (YUM) lost -5% because they derive a majority of their income from stores in China. I think that is overdone since they source their food from inside China to sell in China. The only impact will be repatriating the profits in dollars.



BHP Billiton (BHP) gets 35% of its income from China and shares fell -5%. Rio Tinto (RIO) get 38% of its revenue from China and shares declined -4%. Micron (MU) gets 20% of its revenue there and declined -5%. Wynn Resorts (WYNN) gets 70% of its revenue from China and declined -4.3%.

GoPro (GPRO) was crushed with a -9% loss. I do not know their percentage of Chinese revenue but China is a big market for their high dollar cameras. This will raise the price of those cameras and slow sales.


One stock that did not decline was Google (GOOGL). Late Monday Google announced it was restructuring into a holding company format with the main company called Alphabet. Google shares will still be publicly traded and earnings will be broken out from the other Alphabet companies. Under the Google umbrella will be Google Search, Google Play, YouTube, Google Maps, Android and Google AdSense. Those are the components that make money.

Under the Alphabet banner will be Google Capital, Google X, Google Fiber, Google Nest, Google Ventures and Calico among other things like self driving cars and moonshots. These are the companies that don't make any money.

Google has been criticized a lot in the past for lumping all the "toy" projects in with the revenue generators like Google search. It is hard to know how much Google is really worth since a lot of the expenses were coming from the toys.

Starting in Q4 the Google companies related to search and Android will be broken out from the rest of the Alphabet operations. This will allow Google to be valued based on the market metrics rather than a guess at what the entire bag of tricks was worth.

Shares are still going to trade under the GOOG and GOOGL symbols. All shares of Google will automatically convert into an equal number of shares of Alphabet and retain the same rights. The ticker symbols do not change.

Analysts believe this will enable Alphabet to acquire new businesses and spin off existing ones as needed. They also believe this will increase spending for "revolutionary" ideas while Google itself pays the bills.

Analysts were quick to upgrade the company and provide new price targets.

Cowen & Co, outperform rating, raised target from $775 to $840.

Susquehanna, initiated with a "positive" rating, price target $800.

William Blair, outperform, no target mentioned.

Cantor Fizgerald, buy rating, price target $720.

Deutsche Bank, buy rating, target raised from $780 to $840.

Goldman Sachs, kept at neutral, price target $660.

Morgan Stanley, neutral, target $650.

Pivotal research, hold, target $620.

Pacific Crest, overweight, price target $745.

Stifel, upgrade to buy, increased target to $850.


Earnings were muted today with only a couple high profile companies. Symantec (SYMC) reported earnings of 40 cents on $1.5 billion in revenue. Analysts were expecting 43 cents and $1.52 billion. The company also announced it was selling the Veritas information management business to The Carlyle Group for $8 billion in cash. They expect to receive about $6.3 billion in net proceeds that will be put back to work in their core businesses. Symantec has previously announced plans to split into two companies later this year. The company also announced a $1.5 billion increase in its share buyback program. Those shares are 7% cheaper today after the post earnings sell off.


Fossil (FOSL) slumped -4% in the regular session before reporting earnings after the bell. Shares declined another -6% in afterhours after reporting an earnings beat but a revenue miss. The company also lowered guidance for full year revenue to a range of -1% to +3% growth.


ICU Medical (ICUI) reported an earnings beat after the bell on Monday. Earnings of 97 cents beat estimates of 69 cents. The company raised full year guidance to a range of $3.49-$3.69 with revenue at $327.5 million. Shares spiked +18% on the news.


Zebra Technologies (ZBRA) was mauled by the bears after reporting earnings that missed estimates. Zebra posted earnings of $1.05 compared to estimates for $1.18. Revenue of $890 million beat estimates for $885 million. The company guided for Q3 earnings of $1.23 and analysts were expecting $1.41. Shares fell -24% on the news.


There are two high profile earnings events for Wednesday. Alibaba (BABA) will report before the open and options volatility suggests a $6 post earnings move. The consensus estimate is for earnings of 57 cents. Alibaba still has a 1.2 billion-share lockup expiring on September 20th. I would short any big post earnings rally.

Cisco Systems (CSCO) will report after the bell. The consensus estimate is for earnings of 56 cents.


Crude prices declined -4% on the China headlines and news from OPEC. The cartel said they produced 31.5 million barrels per day in July, up +100,700 bpd from June. This is the highest level since the Iranian sanctions were tightened in 2012. Saudi Arabia said it cut production in July but third party sources show they produced 10.352 mbpd. Iraq raised production by 46,700 bpd to 4.074 mbpd. Angola raised production 39,700 bpd to 1.777 mbpd. Iran, a country that is theoretically constrained on exports increased production 32,300 bpd to 2.861 mbpd.

Going the other direction was Libya declining -37,800 bpd to 373,000 bpd. They have the capability to produce 1.3 million bpd if they could end the civil war.

OPEC increased its demand outlook for 2016 by 100,000 bpd to 94 mbpd. They expect 2016 demand to grow by 1.3 mbpd compared to an increase of 1.5 mbpd in 2015. OPEC said rising demand in the coming months should gradually reduce the imbalance in supply and demand. The cartel said supplies from outside OPEC are expected to rise 90,000 bpd in 2015 and then decline -40,000 bpd in 2016. Non-OPEC suppliers are expected to raise output by 960,000 bpd in 2015 to 57.46 mbpd.


Markets

Ignore today. This was a headline generated panic that has no real bearing on the overall market. While the yuan cloud will hang over the global economy for several weeks the net impact to the U.S. economy will be minimal. Some companies will see lower earnings in future quarters because of the currency translation issue but life will go on.

In the weekend newsletter, I suggested a short squeeze was imminent. We saw that on Monday and the rebound on the major indexes was right to resistance. Today's decline ended at 1:PM with the Dow down -263 points. The reversal was not strong but it was broad. I looked at hundreds of individual charts and the vast majority had decent rebounds in the afternoon.

Today was the perfect opportunity for the bears to take control and they could not push the S&P below Friday's close. Intraday the Monday gains were erased but the rebound from 2077 showed me that buyers were ready and sellers lacked enough conviction to press to a new low.

This was a headline day and nothing more. If the S&P can push back over 2100 and maybe even test 2110 in the coming days then the seller onslaught has been broken. However, as we have seen numerous times over the last several months the markets cannot seem to mount a credible rally other than a one-day short squeeze.

Assuming there are no new headlines overnight I would expect another short squeeze at the open on Wednesday. Obviously, that can be halted by numerous factors but none are visible as I write this commentary.

Resistance is 2100 and 2110 with support at 2077.


The Dow was dragged lower to a -263 point intraday loss by Apple, Goldman, Disney, Caterpillar and 3M. I do not know why Goldman was in that mix of Chinese casualties but it did contribute to the losses.

The Dow declined to 17,350 before managing a +55 point rebound. The Dow remains the weakest index and should continue that performance because nearly all the components are international and will be further hurt by the rising dollar and decline in emerging market currencies. More than half of the Dow components are in correction territory.

Resistance remains 17,600-17,775 and support at 17,300.



The 50-day average crossed below the 200-day on Tuesday. That is called the "death cross" and it an age old sell signal. Time will tell.


The Nasdaq nearly retraced to Friday's low of 5,006 with a low today of 5,013. The afternoon rebound recovered 25 points to end with a -65 point loss. As long as the support at 5,000 remains unbroken the market will eventually recover. A break below that level could trigger a new wave of selling.

Resistance remains 5,100.



The Russell 2000 was a duplicate of the other indexes. The lows of the day were equal to the close on Friday and the afternoon rebound recovered about one-third of the losses. As long as the 1,200 level holds on any further retests we should be fine. Should that level break the next support is 1,150.


The afternoon rebound suggests we could see additional bargain hunting on Wednesday. Should that occur the ranges from Friday and Monday should control our fate. Resistance is strong at 2100-2110 on the S&P and 17,600-17,775 on the Dow.

In the weekend commentary I suggested using any short squeeze as an entry point for short positions. The gap down open today would have been very profitable for anyone following that recommendation. If we return to those resistance levels and fail again I would repeat that strategy. There is no reason for the market to move significantly higher in the short-term.


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Enter passively, exit aggressively!

Jim Brown

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