This week was marked by another round of extreme market volatility and with it came a flurry of research notes explaining to investors what is happening and why.  While most publications focus on very short-term issues –  why are these moves happening, when will they end, what to do now – there are some structural shifts happening beneath the eye-catching headlines that deserve attention.

Last week we discussed how Chinese factories have expanded from just making basic goods to producing higher-value goods as well.  This also affects the global economy in ways that many do not expect.  Even as the world becomes more interdependent on financial flows among countries, actual trade flows are slowing down.  Over the last decade, the statistic rule of thumb has been that trade increased at double the rate of world economic growth, but data released last week showed that trade expanded in Q2 at less than half of global growth. 

A good amount of that is due to the global supply chain in places like China shifting to a phenomenon called “nearshoring” or even “reshoring” in contrast to last decade’s “offshoring,” so that now more of the production cycle exists in one country, to the point where the final product is made and sold in the same country. In the past, Chinese-made basic goods would be shipped to the U.S. for intermediate production, with the final sale in the U.S.

One effect of this is that currency analysis gets a lot more complex.  It used to be that emerging markets like China were known to keep their currency weak so that they could keep their exports cheap.  Now however, intermediate goods production factories in places like China also import key components, and a weak currency makes those imports more expensive.

In addition, investment flows into and out of China have become a much larger determinant of currency value.  Now, the old argument that a weak currency is better for China is no longer always true.  In fact, the World Bank recently released a study showing that currency depreciations between 2004 and 2012 were only half as effective at boosting exports than similar depreciations between 1996 and 2003.

My View: Anyone dealing in global finance needs to pay attention to the shifts in fundamentals, looking past the short-term volatility.

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