How the Currency Headwinds Blow

 | Feb 25, 2014 | 2:00 PM EST  | Comments
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People are starting to notice that China's currency, the renminbi, is falling. It's down about 1% in the past two weeks. Admittedly, that doesn't sound like a lot, but when it comes to currencies, it's a decent move in a short period, especially for currencies that are pegged, which the renminbi is. Moreover, it comes amid rumors of a shift in policy by the People's Bank of China (PBoC).

Since 2004/2005, when the Bush administration and Congress pressured China to let its currency appreciate, the renminbi has been steadily rising. It has gained about 27% in that time in a slow, but steady, rise higher.

The talk now is somewhat of the reverse or, at least, if not the reverse, then an "adjustment" to that policy. People are saying that the PBoC is widening the band in which it allows the renminbi to trade. That band was 0.5% above and below the daily price fixing. A widening would explain some of downward pressure that we are seeing now.

Some people might wonder how the renminbi can fall against the U.S. dollar when China still maintains a large trade surplus against the U.S. After all, don't Chinese exporters need to convert dollars back into local currency, and wouldn't that put pressure on the dollar and drive up the value of the local currency? The answer is no, simply because the central bank can set the rate at which it buys dollars from exporters. It's basically the same mechanism by which the bank sets rates on anything -- interest rates, for example. Therefore, the PBoC may be setting rates lower for the renminbi even as exporters demand more of it. It's a direct subsidy to exporters. Think of it as a fiscal transfer.

Why, then, is this important to us as investors?

For one, look at a company like Wal-Mart (WMT). We all know that Wal-Mart buys a lot of goods from China. And even though the renminbi has been rising for the past nine years, Wal-Mart's stock continued to climb, albeit at a slower pace than in previous periods. The problem was, Wal-Mart had to find other ways to offset the earnings drain from the falling USD/renminbi exchange rate. Another way to say this is that the exchange rate was an earnings headwind.

But what if some of those headwinds are subsiding? That could provide a boost to Wal-Mart's earnings outlook and to its stock, which has lagged the overall market trend since December.

Surely, Wal-Mart could use the help now, especially since Congress recently cut long-term unemployment benefits. That has negatively affected the incomes of many of the people who shop at Wal-Mart. At about $73, the stock is very close to a four-month low. It hasn't reacted yet to the fall in the renminbi and probably for good reason: not a lot of people pay attention to it.

Furthermore, Wal-Mart's numbers look good. It has a low price-to-earnings ratio, decent earnings and the stock pays a dividend. Plus, you get the added bonus of the stock trading near a four-month low. I'd say the risk/reward here is attractive, especially given what could be a very nice catalyst for a rally with this newly emerging exchange-rate trend.

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