China in transition: Five-year expectations

With the broader inclusion of China into global equity and fixed income indices, investors need to understand this unique market.  

In our view, China is neither a traditional emerging market (i.e. commodity-driven) nor a developed one. It has some similarities to its smaller Asian neighbors in its focus on export-driven growth. The government has gradually eased its control and ownership over many sectors of the economy and we expect this to continue into the future, opening up significant opportunities for investors.

Here are some unique characteristics of the Chinese markets:

  • Nominal government bond yields have been well below nominal growth rates since the early 2000s. Although many Western countries have also had yields well below the nominal growth rate since the global financial crisis (GFC), China had them before the GFC and we expect this trend to continue.

Chinese nominal growth and yields

Source: Macrobond. Data as of 31 March 2019.

  • The working age population in China has started to decline. This should help keep yields low and we would expect the productivity growth rate to drop with this. The heady days of 10% real growth are of the past and we expect real (not nominal) growth to be below 6% going forward.
  • The exchange rate is tightly managed. Although the bands have expanded and currency volatility has increased, this is one of the largest currencies that is not completely free-floating.
  • China's equity market has historically been quite volatile. But volatility is declining, and while it is still out of line compared to other markets, we believe it is trending towards emerging market volatility levels. In the past, with an isolated and not well-developed institutional market, Chinese equity market volatility was propelled in part by its large retail market. As access to the Chinese market increases for institutional investors (which tend to have a longer-term outlook) and the weight to China expands in the major indices, we expect this volatility driver to continue to decline. It is worth noting that this increasing share of institutional investors is significantly driven by foreign investors as China continues to open its financial markets. China has tightened rules around trading suspensions, which has greatly reduced the number of trading suspensions in recent years. This is a change from years ago, when Chinese companies were more likely to suspend trading in times of crisis1.  

China's equity market volatility is gradually falling towards the level of emerging markets

Rolling 12-month volatility in local terms

Source: MSCI, S&P, Morningstar Direct, based on monthly data. Data as of 30 June 2019.

10-year standard deviation by market (long terms) through June 2019

Note: Global market designated by MSCI ACWI Index, local terms. Source: MSCI China A, Standard & Poor’s, Morningstar Direct. Data as of 30 June 2019.

  • China's historical correlation to the global market is low. We would expect this to rise slightly in the future.

10-year correlation to global equities by market (local terms) through June 2019

Note: Global market designated by MSCI ACWI Index, local terms. Source: MSCI, Morningstar Direct. Data as of 30 June 2019.

  • Unlike other emerging markets, China exhibits a negative stock-bond correlation in times of stress. Because of its size and enormous investor base, which will demand a safe haven in times of turmoil, we believe that China will maintain this negative stock-bond correlation during stressful periods. However, as indicated in the following chart, the relationship is not stable.

Rolling 12-month correlation: MSCI China A (in CNY) with China Treasuries

Source: MSCI, ChinaBond, Morningstar Direct. Data as of 30 June 2019.

Within the Chinese fixed income market, we follow three sectors: treasuries, policy banks (finance bonds), and corporates. Here are the summary characteristics of these sectors according the Bloomberg Barclays Indices.

China Bond Market - Bloomberg Barclays Indices, June 2019

Sector

Sector

Issues

Issues

Yield to Worst

Yield to Worst

Duration

Duration

Maturity

Maturity

Size In bn USD

Size In bn USD

Percentage of Aggregate Index

Percentage of Aggregate Index

Sector

Treasuries

Issues

156

Yield to Worst

3.15

Duration

6.6

Maturity

9.7

Size In bn USD

1,570

Percentage of Aggregate Index

28

Sector

Policy Banks

Issues

189

Yield to Worst

3.51

Duration

4.4

Maturity

5.3

Size In bn USD

1,789

Percentage of Aggregate Index

32

Sector

Corporate

Issues

1,128

Yield to Worst

4.07

Duration

2.8

Maturity

4.1

Size In bn USD

620

Percentage of Aggregate Index

11

Sector

Aggregate

Issues

2,495

Yield to Worst

3.45

Duration

4.9

Maturity

6.5

Size In bn USD

5,655

Percentage of Aggregate Index

100

In summary, we project the following for Chinese assets in CNY terms. Although we believe that the domestic markets and off-shore markets will converge over time, our equity assumptions specifically refers to the on-shore market.

Summary 5-year return assumptions for Chinese asset classes

 

5-Yr Baseline

10-Yr Baseline

Asset Class

GRR

ARR

Std Dev

GRR

ARR

Std Dev (%)

Cash

2.4

2.4

1.3

3.4

3.4

1.3

China Comm Paper

3.4

3.4

1.4

3.7

3.7

1.4

China Government Bonds

2.6

2.7

4.6

2.8

3.0

4.6

China IG Credit

3.9

4.1

4.7

4.2

4.3

4.7

China Finance Bond

3.2

3.3

4.2

3.5

3.6

4.2

Domestic Equities

8.2

10.4

22.7

8.2

10.2

22.7

In CNY terms, we expect Chinese equities to earn just over 8.0% over the next five to ten years. This represents a healthy premium to both cash investments (around 2.5% to 3.0%) and to Chinese Government Bonds (around 3.0%). 

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