Against a volatile backdrop, onshore China bonds managed to outperform most of their global peers in 2022 due to the liquidity buffer the asset class offers, lower correlation with other global fixed-income markets, and positive real yields. Indeed, easing has been the main tune in regard to Mainland China’s monetary policy in 2022. Offshore China bonds, however, were dictated by another set of dynamics: They were notably affected by ongoing issues in the property sector, resulting in the sharp correction seen among high-yield names within the space.
Key highlights of market performance¹:
- On a year-to-date basis, 10-year China government bond (CGB) yield closed marginally higher at 2.87%, up from 2.78%. Given the onshore market's abundant liquidity, yield levels stayed rangebound between 2.95% and 2.62%.
- Amid a hawkish U.S. Federal Reserve (Fed) and broad risk aversion, the Chinese yuan (CNY) posted a full-year decline of 7.86% against the U.S. dollar (USD). In the fourth quarter, the CNY passed the peak of foreign outflows, which saw the CNY recover to 6.90 against the USD from 7.12 at the beginning of the quarter.
- China USD credit posted -10.45% returns (using J.P. Morgan China Total Return Index as a proxy) during the year owing to higher U.S. Treasury yields and wider credit spreads, although that’s been partially offset by positive carry. Uncertainty about selected property developers’ ability to service their payments or refinance ahead of maturity continued to pressure Chinese property sector bonds.
Toward the fourth quarter of 2022, a major shift to ease COVID-19 restrictions and supportive property sector policies boosted market sentiment. In our view, these measures should help the sector find a bottom over the next 12 to 18 months.
Mainland China’s long-awaited reopening materializes—going on the offensive in 2023
Moving into 2023, our view on the asset class has become more constructive relative to the defensive stance we assumed during the previous year. Indeed, as soon as Mainland China announced a double pivot in the country’s COVID-19 and property sector policies, we started to adopt a more offensive stance in the fourth quarter of 2022:
- Mainland China’s reopening of its borders and the loosening of COVID-19 measures
- The introduction of strong policy “bazooka” with an all-in effort to boost economic growth
- Adopting an all-in approach to support the property sector to achieve a sustained recovery in the real estate space
- The Fed is expected to gradually slow down its rate hikes or pause in 2023
We believe a more offensive stance will continue to benefit from these macro and policy tailwinds operating throughout the fourth quarter of 2022 into the new year, as markets haven’t fully priced in the positive factors and the potential of an improvement in underlying fundamentals. Moreover, the advanced stage of reopening of some Asian economies continues to be a positive factor and one that hasn’t been fully priced in.
After announcing the decision to fine-tune the country’s zero-COVID policies (20 measures) in November 2022, late December saw Mainland China abolish hotel quarantine and on-arrival PCR testing requirements for inbound travelers from January 8, 2023. On December 27, 2022, the government further announced that it would resume issuing tourist and business visas for Chinese mainland residents visiting Hong Kong and begin to reopen the country’s sea and land ports.
We believe that China’s COVID-19 policy U-turn paves the way for a shift to a strategy of living with the virus, which sets the stage for resuming both inbound and outbound travels in the first half of 2023. Whether the return to normality will be gradual or abrupt is still subject to the surge of infections and their potential impact on supply chains. At the time of writing, the real growth rate of Mainland China’s GDP for 2022 is forecast to be 3.0%, followed by 4.8% in 2023, and 5.0% in 2024.²
Our rate, currency, and credit outlook
As the market now expects improved economic growth in Mainland China that may lead to a moderate rebound in inflationary pressures and higher onshore rates, we could see the onshore yield curve steepen. At the same time, the CNY might strengthen in the foreign exchange market. Therefore, having an underweight exposure in duration in our onshore CNY bond portfolios should help buffer the impact of rising rates.
Turning to the foreign exchange space, the CNY will likely benefit from the domestic economic recovery, more substantial policy stimulus, and a USD that may be peaking in value. Higher rates would also attract portfolio flows to the onshore markets as the interest-rate differential between the CNY and USD should narrow, providing support to the renminbi. Therefore, we believe that the outlook for the renminbi has become more constructive, and investors could potentially benefit from a reduction of CNY hedges against the USD.
Regarding different segments of China bonds in the onshore market, we maintain a relatively cautious view of corporate credit and bank capital bonds as valuations appear unattractive. We’re more neutral on policy bank bonds and CGBs. Simultaneously, as investors seek to benefit from the country’s reopening, there’s the potential to increase their offshore China USD-denominated high-yield exposure due to the latter’s attractive valuations. From a sector perspective, we believe it makes sense to identify opportunities to selectively add higher-quality property developers, especially state-owned enterprise developers that benefit from greater state support. We also believe adding some exposure to internet and technology names that are well positioned to gain from a domestic recovery could make sense..
Currently, the opportunity set for sustainable investing remains predominantly in the offshore USD market; however, once the onshore green-bond market develops further and becomes more scalable, it could offer multiple investment possibilities.
There could be more targeted support for the real estate sector
In the new year, we expect more supportive measures for the property sector following the financing support announced (widely known as the second arrow) in November 2022. Significantly, in early January, the People’s Bank of China (PBoC) and the China Banking and Insurance Regulatory Commission announced a bold new initiative to establish a new mortgage rate adjustment framework for first-time home buyers when housing prices drop. This will likely result in a material decline in these buyers’ mortgage rates and could be supportive for the property sector. At the same time, market headlines suggest that China is considering relaxing its stringent three red lines property rules for some developers. If implemented, this would represent a significant policy shift and will likely build investor confidence in the sector.
Indeed, the recovery story depends on how quickly developers can reinstate cash flow, but as the economy reopens, there may be an uptick in household incomes that, in turn, should result in increased property transactions. A headwind to note is the slowdown in the United States and Europe could have a knock-on effect on Mainland China’s export manufacturing sector, which may affect employment levels. Overall, the recovery should be quite meaningful in the second half of 2023 but possibly less robust (a u-shaped rebound) than the post-COVID-19 upturn (a v-shaped rebound) in 2020.
Adopting a pragmatic approach with fiscal stimulus
We believe the government and policymakers will be mindful of the aforementioned factors and will likely observe how the reopening plays out before considering further fiscal stimulus. In terms of official benchmark interest rates, these should remain on hold with no changes expected until late 2023, which could coincide with the Fed reaching its terminal interest rate. Indeed, we may have already reached the maximum interest-rate policy differential between the PBoC and the Fed. As such, as Mainland China reopens and the Fed is in the latter stages of its tightening cycle, currency depreciation pressures have probably peaked. As we have detailed previously, China bonds can serve as a potentially resilient risk diversifier due to the asset class’s low correlation to other parts of the global fixed-income market, decent interest-rate carry (on a hedged basis), and abundant onshore liquidity.
Why risk and liquidity management processes matter
When we look back at the challenging market environment in 2022, one of the key takeaways we want to emphasize is the need to maintain a highly liquid portfolio—either with cash or equivalents such as short-term U.S. Treasuries during periods of market turmoil. Our investment team’s long track record and deep experience in Mainland China's onshore bond market³ have helped the team navigate treacherous market conditions. By adopting a higher level of liquidity under such conditions, investors are able to methodically manage their way through a volatile market cycle. At the same time, maintaining a diversified portfolio can further reduce the downside impact.
In summary, we believe liquidity and diversification remain essential, as do perseverance and patience.
Finally, we expect low-to-mid single-digit returns for CNY onshore bond investors in this space and reiterate the appeal of China bonds to global investors.
Appendix: Mainland China—monetary easing in 2022
First quarter: The PBoC lowered its policy rates by 10 basis points (bps), including the seven-day repo rate from 2.2% to 2.1% and its one-year medium-term lending facility (MLF) interest rate from 2.95% to 2.85% on January 17, 2022. This was followed by a reduction in the banks’ loan prime rate (LPR), which was reduced by 10bps to 3.70% for the one-year rate and by 5bps to 4.60% for the five-year rate.
Second quarter: The PBoC reduced its required reserved ratio for banks (RRR) by 0.25% in April. As a result, average RRR in the banking system fell to 8.10% from 8.40%. The PBoC also cut the five-year LPR by 15bps to 4.45% to boost mortgage support while leaving the one-year LPR unchanged at 3.70%.
Third quarter: The PBoC cut policy rates (one-year MLF and its seven-day reverse repo rate) by 10bps to 2.75% and respectively in August. This was followed by asymmetric cuts in LPRs with the one-year LPR reduced by 5bps to 3.65% while the five-year LPR was cut by 15bps to 4.3% to support the property market.
Fourth quarter: The PBoC announced a universal RRR cut on November 25, 2022.
1 Bloomberg, data as of December 28, 2022. USD/CNY was as high as 7.3050 on October 31, 2022, and depreciated to 6.9501 as of December 28, 2022. 2 Based on Bloomberg consensus forecasts. 3 We established our onshore China bond performance track record in 2010.
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
Investing involves risks, including the potential loss of principal. Financial markets are volatile and can fluctuate significantly in response to company, industry, political, regulatory, market, or economic developments. These risks are magnified for investments made in emerging markets. Currency risk is the risk that fluctuations in exchange rates may adversely affect the value of a portfolio’s investments.
The information provided does not take into account the suitability, investment objectives, financial situation, or particular needs of any specific person. You should consider the suitability of any type of investment for your circumstances and, if necessary, seek professional advice.
This material is intended for the exclusive use of recipients in jurisdictions who are allowed to receive the material under their applicable law. The opinions expressed are those of the author(s) and are subject to change without notice. Our investment teams may hold different views and make different investment decisions. These opinions may not necessarily reflect the views of Manulife Investment Management or its affiliates. The information and/or analysis contained in this material has been compiled or arrived at from sources believed to be reliable, but Manulife Investment Management does not make any representation as to their accuracy, correctness, usefulness, or completeness and does not accept liability for any loss arising from the use of the information and/or analysis contained. The information in this material may contain projections or other forward-looking statements regarding future events, targets, management