Our team has for a long time been flagging up a strategic case for investing in China’s onshore markets. China bonds, in particular, is an exciting, large but still growing asset class, which offers investors the benefits of solid credit quality, higher yield and diversification.
Despite the current difficult environment for global financial markets, we believe that the case for China is now even stronger.
China was the first country hit by COVID-19, but that means it is now emerging as the first country to get the outbreak under control. Thanks to the strong measures taken by Chinese government to control the virus, its effective stimulus program and loan forbearance by the banking system, corporate China appears to have weathered the storm well, facilitating a rapid recovery of economic capacity.
Many manufacturers closed factories only for two weeks. Based on our own research insights, local industry surveys and recent Purchasing Managers’ Index releases, we estimate that production practically stopped during much of February, but work rates climbed from 30 – 40% in the first week of March to 50 – 60% in the second week to 70 – 80% in the third week for most manufacturers, with the delay mostly due to labor or inventory shortages. While consumer-facing businesses have lagged the recovery, we are beginning to see them re-open one month after the peak of the crisis. The travel and leisure sectors are among the last to emerge—although exporters may still face difficulties ahead.
We can see that resilience in China’s currency, which, unlike most developed market currencies, has avoided steep depreciation against the rampant U.S. dollar. The renminbi lost only 1.5% of its value against the dollar in the first quarter of 2020. We believe local policymakers can and will support the currency around current levels, but currency hedging is also a feasible option, given the moderate cost of hedging, currently around 1% to hedge back to dollars.
China may be one of the most attractive markets to seek out exposure to the economic recovery from the COVID-19 crisis. But one could even argue that, for the coming weeks and months, China bonds now look more like a source of relative stability for global investors than an emerging market.
Three Reasons to Consider China Onshore Bonds
Attractive yield versus other bond markets. Ten-year China Government Bonds were yielding around 2.6% at the end of March. At almost 200 basis points, that is the highest recorded spread over U.S. Treasuries. With more rate cuts anticipated across the world’s economies and a growing mountain of negatively yielding debt, China stands out as an attractively priced sovereign credit. Even in a recovery scenario, we think rates should remain stable since output gaps in local economy are likely to mitigate upward pressure.
Resilience in adverse market conditions. We’ve written before about the diversification benefits of onshore China bonds. It came to the fore again during the current market sell-off, when China bonds proved their resilience in very difficult circumstances. By the end of March, when China was reporting zero additional local cases of COVID-19, the year-to-date return of the S&P China Bond Index was 2.55%, making this market the best performing segment in the entire global fixed income universe. For comparison, the Bloomberg Barclays Global Aggregate USD Hedged Index returned -0.12% over the same period, while local-currency emerging markets debt benchmarks were in double-digit negative territory along with many other risk markets. International redemptions made liquidity much more difficult in the offshore China bond market than in the onshore market—in fact we are finding attractive opportunities to provide liquidity in that market ourselves, raising the offshore bond allocation in some of our portfolios.
Attractive risk premium for corporates with government support. With China already returning to work, the bulk of the COVID-19 impact on corporate earnings will have been felt in the first rather than the second quarter of the year. Government guidance on loans to state- and privately owned businesses ensured a continuation of credit support which is now paying off in terms of keeping corporate defaults at bay. We anticipate much higher default rates across other emerging markets. While the export-oriented industry segments will be challenged for some time as the rest of the world fights through the crisis, most sectors, including the all-important real estate sector, are in recovery. Both production and consumption are coming back to life, further supported by government stimulus in the areas like infrastructure spending.
In summary, we believe that China bonds present a great opportunity for fixed income investors today, allowing them to benefit from China’s earlier recovery from the COVID-19 crisis.
In Equities, the Initial Rally Was a False Dawn
Those with more confidence in the recovery or greater risk tolerance may wish to consider China equities. One of the great surprises of the crisis so far has been the remarkable resilience of China A shares. The Shenzhen A Share Index ended just about flat over the first quarter, and while it has had ups and downs over that time they have been very muted relative to the wild ride seen in other developed and emerging stock markets.
The market had been up by 10% for the year at the end of February, but that turned out to be a false dawn—as we thought it might. Investors relieved to see COVID-19 subside at home neglected to consider the impact that the spread of the virus worldwide would have on demand for China’s export sectors. Some of those sectors are down 20 – 30% from the recent market peak.
Valuations here may be attractive, but there is a lot of uncertainty to take into account. Earnings were already down in the first quarter due to the domestic health crisis, and a protracted global demand shock could worsen the situation for exporters.
Where we are adding positions on attractive valuations is in high-quality companies in two main areas. The first are those which can benefit from policy stimulus, such as names in the infrastructure sector. The second are those which can benefit from the incipient recovery in domestic consumer demand, and which exhibit strong enough cash flow to see them through any difficulties to come.
Overall, we believe that China’s onshore markets are among the most interesting exposures to consider for exposure to the early stages of the recovery from the COVID-19 crisis. Perhaps more importantly, once the crisis subsides worldwide, their remarkable resilience over the past three months may cause investors to change their view of these markets for good.