The Yuan and You


By Sam Stovall China's unexpectedly sudden move to revalue its currency, the yuan, on July 21, has sparked much speculation as to its ultimate effect on world markets. But what does it mean for U.S. investors? And should they make any changes in strategy?

First, let's examine how the move may play out, looking at the positive side of the ledger first. Standard & Poor's thinks China's plan is likely to have several beneficial effects. Specifically, the revaluation is likely to trim the U.S. trade deficit with China in the longer term, as the increased cost of imported goods eventually reduces demand.

In the short-run, however, our trade gap may actually widen, as the pace of price increases for imported goods will outweigh businesses' efforts to secure less-expensive substitutes.

PRESSURE RELIEF. The revaluation is also likely to improve the competitiveness of U.S. goods in U.S. markets against more expensive Chinese goods (if the U.S. still produces goods that are in direct competition with their Chinese counterparts, that is). On the other hand, Chinese suppliers may decide to reduce the nominal cost of the exported items to offset the effect of the stronger yuan.

The move could relieve pressure on key political fronts as well by reducing the threat of trade sanctions imposed by the U.S. Congress on Chinese imports, and by possibly helping to stem the tide of U.S. job losses overseas. It's likely to weaken the value of the U.S. dollar from a reduced need to peg the yuan to the dollar. (Manufacturing groups have cited a strong U.S. dollar as an impediment to U.S. export competitiveness.)

For China's part, economic growth there may slow from the 9.5% rate recorded for the second quarter, in S&P's opinion -- an outcome that could please Beijing, as policymakers there have been trying to moderate the pace of economic growth. Lastly, oil prices may decline as a result of reduced Chinese demand (See BW Online, 7/19/05, "China's Shrunken Thirst for Oil").

THE BIG PICTURE. However, there are also some likely negatives from the move. The revaluation is likely to raise the cost of Chinese imports, thus putting pressure on margins for retail and tech companies.

Another possibility is that the revaluation could increase the threat of higher inflation in the U.S. as a result of these higher costs. Gold prices could rise in response, as they traditionally do on the possibility of higher U.S. prices for goods and services. S&P thinks the prices of other metals may rise in response to the prospects of reduced competition from Chinese exports.

Amid the conflicting currents, then, it's important to study the balance of positives and negatives, and put them into context. In reality, according to Beth Ann Bovino, senior economist for S&P, the move to peg the yuan to a basket of currencies was expected, and the overall economic effect should be small.

Overall, S&P believes the removal of the dollar peg is a positive, as it addresses a major imbalance in the world economy. But the initial adjustment was on the modest side, revaluing by 2.05% vs. the dollar. It probably won't satisfy U.S. government calls for currency adjustment, which will likely intensify when President Hu of China visits Washington in the fall. We think the small appreciation vs. the dollar won't have much of an impact on the U.S. current account deficit.

MAINTAINING BALANCE. Even if Beijing ratchets up the revaluation strategy to a 5% adjustment, the overall economic and market impact shouldn't be that great, in our opinion. As of July 22, the euro was at 1.219 vs. the dollar, little changed from where it was on July 20. The Japanese yen has gained more than 1% vs. the dollar since the move by China, but we believe a 1% impact won't likely push the Bank of Japan to increase their purchases of U.S. Treasuries. (Japan has intervened in currency markets in the past to prevent excessive appreciation of the yen vs. the dollar.)

And in the Middle Kingdom, the impact may not be dramatic either. Since many China-based companies source and manufacture locally, S&P analysts believe the yuan revaluation will only have a modest impact. However, a key positive is that earnings generated in China will be greater after conversion to other currencies. And in a spillover effect, the recent strength in the yen engendered by the move could benefit U.S. companies with a presence in Japan.

Finally, should the yuan revaluation make any difference to a U.S. investors' overall strategy? Well, S&P continues to recommend that the typical investor who aims for a balanced portfolio should have a 50% exposure to U.S. equities and a 15% holding in foreign stocks, while maintaining 20% in short-to-intermediate term bonds, and 15% in cash. Our yearend 2005 target for the S&P 500 is 1270, implying a more than 5% advance from the yearend 2004 level.

Glossary

S&P STARS: Since January 1, 1987, Standard & Poor's Equity Research Services has ranked a universe of common stocks based on a given stock's potential for future performance. Under proprietary STARS (STock Appreciation Ranking System), S&P equity analysts rank stocks according to their individual forecast of a stock's future capital appreciation potential versus the expected performance of a relevant benchmark (e.g., a regional index (S&P Asia 50 Index, S&P Europe 350 Index or S&P 500 Index), based on a 12-month time horizon. STARS was designed to meet the needs of investors looking to put their investment decisions in perspective.

S&P Earnings & Dividend Rank (also known as S&P Quality Rank): Growth and stability of earnings and dividends are deemed key elements in establishing S&P's earnings and dividend rankings for common stocks, which are designed to capsulize the nature of this record in a single symbol. It should be noted, however, that the process also takes into consideration certain adjustments and modifications deemed desirable in establishing such rankings. The final score for each stock is measured against a scoring matrix determined by analysis of the scores of a large and representative sample of stocks. The range of scores in the array of this sample has been aligned with the following ladder of rankings:

A+

Highest

B

Lower

A

High

C

Lowest

A-

Above Average

D

In Reorganization

B+

Average

NR

Not Ranked

B-

Below Average

S&P Issuer Credit Rating: A Standard & Poor's Issuer Credit Rating is a current opinion of an obligor's overall financial capacity (its creditworthiness) to pay its financial obligations. This opinion focuses on the obligor's capacity and willingness to meet its financial commitments as they come due. It does not apply to any specific financial obligation, as it does not take into account the nature of and provisions of the obligation, its standing in bankruptcy or liquidation, statutory preferences, or the legality and enforceability of the obligation. In addition, it does not take into account the creditworthiness of the guarantors, insurers, or other forms of credit enhancement on the obligation. The Issuer Credit Rating is not a recommendation to purchase, sell, or hold a financial obligation issued by an obligor, as it does not comment on market price or suitability for a particular investor. Issuer Credit Ratings are based on current information furnished by obligors or obtained by Standard & Poor's from other sources it considers reliable. Standard & Poor's does not perform an audit in connection with any Issuer Credit Rating and may, on occasion, rely on unaudited financial information. Issuer Credit Ratings may be changed, suspended, or withdrawn as a result of changes in, or unavailability of, such information, or based on other circumstances.

S&P Core Earnings: Standard & Poor's Core Earnings is a uniform methodology for calculating operating earnings, and focuses on a company's after-tax earnings generated from its principal businesses. Included in the Standard & Poor's definition are employee stock option grant expenses, pension costs, restructuring charges from ongoing operations, write-downs of depreciable or amortizable operating assets, purchased research and development, M&A related expenses and unrealized gains/losses from hedging activities. Excluded from the definition are pension gains, impairment of goodwill charges, gains or losses from asset sales, reversal of prior-year charges and provision from litigation or insurance settlements.

S&P 12 Month Target Price: The S&P equity analyst's projection of the market price a given security will command 12 months hence, based on a combination of intrinsic, relative, and private market valuation metrics.

Standard & Poor's Equity Research Services: Standard & Poor's Equity Research Services U.S. includes Standard & Poor's Investment Advisory Services LLC; Standard & Poor's Equity Research Services Europe includes Standard & Poor's LLC- London and Standard & Poor's AB (Sweden); Standard & Poor's Equity Research Services Asia includes Standard & Poor's LLC's offices in Hong Kong, Singapore and Tokyo.

Required Disclosures

In the U.S.

As of March 31, 2005, research analysts at Standard & Poor's Equity Research Services U.S. have recommended 30.8% of issuers with buy recommendations, 56.7% with hold recommendations and 12.5% with sell recommendations.

In Europe

As of March 31, 2005, research analysts at Standard & Poor's Equity Research Services Europe have recommended 29.2% of issuers with buy recommendations, 50.5% with hold recommendations and 20.3% with sell recommendations.

In Asia

As of March 31, 2005, research analysts at Standard & Poor's Equity Research Services Asia have recommended 34.3% of issuers with buy recommendations, 48.0% with hold recommendations and 17.7% with sell recommendations.

Globally

As of March 31, 2005, research analysts at Standard & Poor's Equity Research Services globally have recommended 31.0% of issuers with buy recommendations, 55.2% with hold recommendations and 13.8% with sell recommendations.

5-STARS (Strong Buy): Total return is expected to outperform the total return of a relevant benchmark, by a wide margin over the coming 12 months, with shares rising in price on an absolute basis.

4-STARS (Buy): Total return is expected to outperform the total return of a relevant benchmark over the coming 12 months, with shares rising in price on an absolute basis.

3-STARS (Hold): Total return is expected to closely approximate the total return of a relevant benchmark over the coming 12 months, with shares generally rising in price on an absolute basis.

2-STARS (Sell): Total return is expected to underperform the total return of a relevant benchmark over the coming 12 months, and the share price is not anticipated to show a gain.

1-STARS (Strong Sell): Total return is expected to underperform the total return of a relevant benchmark by a wide margin over the coming 12 months, with shares falling in price on an absolute basis.

Relevant benchmarks: in the U.S. the relevant benchmark is the S&P 500 Index, in Europe the S&P Europe 350 Index and in Asia the S&P Asia 50 Index.

For All Regions:

All of the views expressed in this research report accurately reflect the research analyst's personal views regarding any and all of the subject securities or issuers. No part of analyst compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this research report.

Additional information is available upon request to Standard & Poor's, 55 Water Street, NY, NY.

Other Disclosures

This report has been prepared and issued by Standard & Poor's and/or one of its affiliates. In the United States, research reports are prepared by Standard & Poor's Investment Advisory Services LLC ("SPIAS"). In the United States, research reports are issued by Standard & Poor's ("S&P"), in the United Kingdom by Standard & Poor's LLC ("S&P LLC"), which is authorized and regulated by the Financial Services Authority; in Hong Kong by Standard & Poor's LLC which is regulated by the Hong Kong Securities Futures Commission, in Singapore by Standard & Poor's LLC, which is regulated by the Monetary Authority of Singapore; in Japan by Standard & Poor's LLC, which is regulated by the Kanto Financial Bureau; and in Sweden by Standard & Poor's AB ("S&P AB").

The research and analytical services performed by SPIAS, S&P LLC and S&P AB are each conducted separately from any other analytical activity of Standard & Poor's.

Disclaimers

This material is based upon information that Standard & Poor's considers to be reliable, but neither S&P nor its affiliates warrant its completeness, accuracy or adequacy and it should not be relied upon as such. With respect to reports issued by S&P LLC-Japan and in the case of inconsistencies between the English and Japanese version of a report, the English version prevails. Neither S&P LLC nor S&P guarantees the accuracy of the translation. Assumptions, opinions and estimates constitute Standard & Poor's judgment as of the date of this material and are subject to change without notice. Neither S&P nor its affiliates are responsible for any errors or omissions or for results obtained from the use of this information. Past performance is not necessarily indicative of future results.

This material is not intended as an offer or solicitation for the purchase or sale of any security or other financial instrument. Securities, financial instruments or strategies mentioned herein may not be suitable for all investors. Any opinions expressed herein are given in good faith, are subject to change without notice, and are only correct as of the stated date of their issue. Prices, values, or income from any securities or investments mentioned in this report may fall against the interests of the investor and the investor may get back less than the amount invested. Where an investment is described as being likely to yield income, please note that the amount of income that the investor will receive from such an investment may fluctuate. Where an investment or security is denominated in a different currency to the investor's currency of reference, changes in rates of exchange may have an adverse effect on the value, price or income of or from that investment to the investor. The information contained in this report does not constitute advice on the tax consequences of making any particular investment decision. This material does not take into account your particular investment objectives, financial situations or needs and is not intended as a recommendation of particular securities, financial instruments or strategies to you. Before acting on any recommendation in this material, you should consider whether it is suitable for your particular circumstances and, if necessary, seek professional advice.

For residents of the U.K.: This report is only directed at and should only be relied on by persons outside of the United Kingdom or persons who are inside the United Kingdom and who have professional experience in matters relating to investments or who are high net worth persons, as defined in Article 19(5) or Article 49(2) (a) to (d) of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2001, respectively.

Readers should note that opinions derived from technical analysis might differ from those of Standard & Poor's fundamental recommendations. Stovall is chief investment strategist for Standard & Poor's


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