At a glance
- Modest growth and inflation in China place bonds in a sweet spot.
- Policy is easier to counter growth and deleveraging headwinds.
- We think the near-term risk of significant renminbi depreciation is limited, unless the US presses ahead with 25% tariffs across all imports.
- Increasing momentum in the inclusion of onshore bonds in global indices will hasten the ‘mainstreaming’ of Chinese fixed income and potentially spark significant fund flows.
- We believe the valuation correction offshore generates attractive investment opportunities.
Modest growth and inflation
In its October 2018 update to the World Economic Outlook, the IMF revised marginally lower its projections for China’s growth and inflation – growth over 2019-2020 is expected to moderate towards 6.2% per annum, while consumer price inflation stays anchored in the 2.4-2.7% range. Such an environment of modest growth and inflation places bonds in a sweet spot.
Figure 1: The China fixed income proposition
Source: IMF World Economic Outlook Database, October 2018.
Indeed, China’s growth slowdown, from 6.8% year-on-year in the first quarter of 2018 towards 6.5% in the third quarter of 2018, has been due mainly to policy-induced deleveraging onshore. While the intensity of the deleveraging process has eased somewhat, we believe the direction of travel will continue. From an external perspective, while the direct impact of US tariffs has yet to be seen in the hard data, we expect the impact to start coming through more meaningfully in 2019. Consequently, we see headwinds from both internal and external factors.
To offset these headwinds, policy has become more accommodative. On the monetary front, reserve requirements were cut three times in 2018 and there is significant room for further relaxation if required. Fiscal policy has also turned more supportive, most recently in the form of personal income tax deductions scheduled to take effect from 2019, with VAT and corporate income tax cuts likely to be next.
In this context, we think that onshore bond yields will remain well supported over 2019, and expect further interest rate divergence between the US and China.
Currency likely more two-way
The ratcheting-up of US-China trade tensions in 2018, coupled with slower domestic growth on the back of deleveraging, saw the Chinese renminbi (CNY) give up its early 2018 gains against the dollar to weaken another 6.5%. At almost 7.0 CNY to the dollar1, we think the near-term risk of significant renminbi depreciation is limited. The destabilising impact of further depreciation on sentiment would see the authorities act to support the currency, as was the case when it re-applied the counter-cyclical adjustment factor in August. Moreover, any further depreciation will only serve to worsen relations with the US and jeopardise chances of negotiation. Fundamentally, China still runs a significant trade surplus against the US. However, should the US press ahead with imposing 25% tariffs on all imports from China, there is a risk that the CNY may weaken somewhat to offset this.
More broadly, with its high domestic savings, little reliance on foreign financing, tight reins on resident capital outflows and improved policy coordination, China has meaningful domestic levers to support growth. Longer term, support for CNY ultimately lies in improved productivity and investment prospects in China – levelling the playing field between state-owned and private/ foreign-owned enterprises will be paramount in fully realising these objectives. To this end, the pursuit of stable growth conditions, economic transformation and continued market-oriented reforms are key.
Mainstreaming of Chinese bonds
Operational enhancements to ease foreign investor access mean that there is a good chance that Bloomberg Barclays starts including China in the widely followed Global Aggregate Index from April 2019. We think JP Morgan could start including China in the GBI EM Global Diversified Index in the second half of 2019, with FTSE Russell to follow with the World Government Bond Index.
If this comes to pass, it should provide significant inflows into the bond market over the next couple of years. Most estimates are in the region of US$250 billion-US$300 billion. 2019 could be the year where we see these index inclusions mainstream Chinese fixed income as a core allocation in global portfolios.
Valuations present attractive opportunities
US dollar China bond yields have repriced with US interest rates higher and credit spreads wider. This is a healthy correction from tight levels back in 2016/17. Towards 6% at the aggregate level, we think that this is beginning to present attractive opportunities.
Figure 2: Repricing in US dollar China corporate credit
Source: JPM Asia Credit Index China Yield to Worst, 31.10.2018.
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