China bonds: a potentially resilient risk diversifier
The fixed-income market has clearly experienced some extreme volatility recently, with global fixed-income assets suffering double-digit losses; however, despite the headwinds, China bonds have remained resilient, outperforming year to date. Our experts explain why they believe China bonds’ favorable fundamentals have remained intact and could continue to provide support going forward.
As we enter the final quarter of 2022, it may be useful for investors to reflect on the China bond market and review its performance so far this year. We also highlight some of the important market themes that we’re monitoring into the year end.
Without overstatement, market behavior in 2022 can clearly be characterized as one of extreme volatility. We’ve seen the first major European conflict since World War II as well as double-digit inflation sweeping the eurozone and other major economies. In response, global central banks, led by the U.S. Federal Reserve (Fed), which has so far tightened monetary policy, including raising interest rates by 300 basis points (bps) this year, are scrambling to tighten monetary policy to contain inflation risks. Their actions have compounded market turmoil and heightened risks of a global recession. Unsurprisingly, global fixed income—as an asset class—has suffered unprecedented double-digit losses under such extremely disruptive conditions.
In China, macro pressure also intensified in the second quarter, after Omicron-related lockdowns disrupted its economic recovery. To cushion the shocks, the People’s Bank of China (PBoC) cut rates by 10bps in both the first and third quarter. The property slump in China also deepened despite the introduction of property support measures, which included mortgage easing and government financing support for private developers. Meanwhile, the Chinese yuan (CNY) further weakened by 6% against the U.S. dollar (USD) in the third quarter, breaking past the key 7.00 level, until the PBoC’s intervention helped to stabilize the CNY, preventing the currency from rising above the 7.25 level. Given the increasing monetary policy divergence between the PBoC and the Fed, with the former cutting rates, while the latter continues to hike, the CNY/USD interest-rate differential declined to around -250bps from over +200bps just a year ago. Subsequently, both the Chinese equity and bond markets have seen outflows.
China bonds: resilience and liquidity despite macro headwinds
Over the last few weeks of September, investor sentiment reached extremely bearish levels after the violent moves in sterling and gilt rates jolted global interest-rate and currency markets and left financial stress signals flashing red. Despite the extreme market volatility and macro headwinds, we believe the Chinese bond market’s resilience and strong liquidity have been outstanding: The market outperformed both its emerging market/Asia peers and core U.S./EU government bonds. Chinese onshore government bonds returned -7.2% year to date (as of September 30, 2022) compared with -19.9% for global aggregate bonds. On a foreign exchange hedged basis, China bonds (Bloomberg China Treasury Total Return Index Hedged in USD terms) have generated a positive return of 2.3% on the back of the PBoC’s two rate cuts.
Contracting CNY/USD interest-rate differential has led to CNY weakening
Source: Manulife Investment Management, Bloomberg, as of October 3, 2022. The blue line represents the trendline. The green line represents the year-to-date movement of the interest-rate differential from December 2021 to September 2022. The gray dots represent the historical relationship between USD/CNY and the China-U.S. interest-rate differential, based on weekly data from November 2006 to October 2022.
In many investors’ portfolios, Chinese onshore bonds (Bloomberg China Treasury Total Return Index Hedged in USD terms) were the only positive returning asset class while also successfully acting as a liquidity buffer under severe market stress. On a volatility-adjusted basis, Chinese bonds also stand out given their low correlation to other parts of the fixed-income market. This contrasts with the double-digit drawdowns that their peers experienced during the period: -13.0% in U.S. Treasury, -14.6% in U.S. aggregate, -24.0% in USD-denominated emerging-market debt, -27.8% in euro bonds, and -22.9% in Japan bonds.
Chinese government bonds differentiate on favourable fundamentals
We have often argued that an overweight allocation to the Chinese government bond market could be beneficial for global investors, especially when markets have been volatile. In light of the global market turmoil in 2022, it’s worth reiterating the following favorable fundamentals for China bonds:
- Low and benign inflation: Inflation is the biggest threat to fixed-income investors. China’s less aggressive COVID-19 policy response (stimulus applied in 2020/2021) and greater resilience to the energy shocks emanating from Russia’s invasion of Ukraine have helped to keep a lid on inflation.
- The PBoC’s easing cycle: The central bank has introduced gradual rate cuts and balance sheet expansion, in contrast to its G7 peers, the majority of whom have accelerated rate hikes and turned to quantitative tightening.
- A relatively stable currency: The CNY has been relatively stable, supported by a large current account surplus, competitive exports, lower terms-of-trade shocks, and supply chain disruptions resulting from the conflict in Europe.
- Lower correlation to U.S./global rates: Yields on China bonds are largely domestically anchored by local investors and therefore remain less correlated to U.S. and global interest rates.
China USD high-yield bonds remain volatile although valuations are looking attractive for selected names
While onshore China government bonds and high-quality investment-grade bonds have been relatively stable, China USD-denominated high-yield bonds—which are on the riskier end of the credit spectrum—suffered heavy losses of -37% year to date (using the J.P. Morgan Asia Credit Index (JACI) China High Yield TR Index as a gauge). Most private property developers, except a few of the most conservative ones, are headed for restructuring and possible defaults following the most severe China property downturn of the past 30 years.
Given the record sell-off, valuations for selected names are looking attractive, although we’re some way off from a full recovery in the high-yield space within the China property sector.
China government bonds have outperformed U.S. and global fixed-income assets this year
Source: Bloomberg, J.P. Morgan indexes, as of September 30, 2022. YTD refers to year to date. TR refers to total return. EMB refers to emerging-market bonds.
Closely monitoring potential policy pivots
We’ve maintained a mostly defensive stance in 2022, making the case for reduced credit beta while being highly selective in any exposure to high-yield credit. We also believe that it makes sense to consider raising portfolio liquidity buffers by increasing exposure to government securities and applying a structural overweight in China duration. In our view, these actions can help to reduce overall volatility and, in our experience, act as a buffer against drawdowns.
Looking to the period ahead, we’re closely watching critical policy pivots that may result in potential market rallies for China bonds. Such policy pivots may include:
- The reopening trade—the expected staged exit of China’s COVID-zero policy in 2023 could put China’s economic recovery on a firmer footing.
- All-in policy bazooka—intensifying policy support addressing the economic downturn and China property slump that could dramatically improve the outlook for China-related risk assets.
- Fed’s dovish pivot—softening U.S. inflation dynamics and possible turnaround to the Fed’s tightening cycle would be a boost to global sentiment.
- Global volatility and spillovers—any potential European, British, and Japanese policy response to stagflation shocks, dislocation in foreign exchange, rates, and credit markets could support markets.
We will also be monitoring upcoming events, including China’s 20th National Party Congress on October 16, the G20 Summit on November 15, and 2022’s final FOMC meeting on December 14 for macro direction.
Given improved market valuations after the record market sell-off this year, we believe it makes sense for investors to adopt a slightly more constructive stance. This can include keeping an eye on opportunities to selectively adding China high-yield credit with explicit and implicit government support, reducing duration in China rates on expectations of strong economic stimulus, and maintaining a marginal underweight in CNY and U.S. rates where sensible.
While it’s evident that global markets have faced considerable volatility and dislocation in 2022, China bonds have proven to be resilient and attractive as a diversifier of risk under such conditions. We believe the favorable fundamentals for China bonds remain intact and that they’ll continue to support the asset class going forward. Potential policy pivots and upcoming events may also prove to be attractive catalysts for further outperformance by China bonds.
A widespread health crisis such as a global pandemic could cause substantial market volatility, exchange-trading suspensions and closures, and affect portfolio performance. For example, the novel coronavirus disease (COVID-19) has resulted in significant disruptions to global business activity. The impact of a health crisis and other epidemics and pandemics that may arise in the future, could affect the global economy in ways that cannot necessarily be foreseen at the present time. A health crisis may exacerbate other pre-existing political, social and economic risks. Any such impact could adversely affect the portfolio’s performance, resulting in losses to your investment
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