The long-term investment case for onshore China fixed income is likewise intact. Given the still relatively low global yield environment and the low correlation between China and global rates, we expect China fixed income to remain attractive vis-a-vis other global bond markets both on a yield basis and also from a diversification point of view.
In the short term, we expect the China fixed income market to still trade based on domestic economic fundamentals that are under huge downward pressure. Exports are expected to remain relatively strong despite COVID lockdowns in several cities, which will add to GDP growth in 2022, but with the ongoing Ukraine war, European and US demand could slow and add to the pressure from the global economic slowdown. Both factors could trigger more aggressive monetary and fiscal stimulus in China. We think there is still room for China rates and monetary policy to be accommodative, as stated in a government work report by Premier Li Keqiang on behalf of the State Council. This will continue to support China fixed income.
With the US Federal Reserve back on a rate hiking path and monetary policy diverging between China and the US, the difference in interest rates is narrowing as US rates rise. Market concerns about the China-US yield advantage has led to some short-term volatility in China rates, but we think the concerns may be exaggerated. This is not the first time that we see diverging economic and monetary policies in the US and in China. For example, in 2018 when US yields were on an upward trend, China faced an economic downturn and the People’s Bank of China implemented four rounds of reserve requirement ratio (RRR) cuts despite continuous rate hikes stateside. Looking back, the outflows from China bonds by foreign institutions and the resulting depreciation pressure on the Chinese yuan (CNY) in 2018 was larger compared to what we see currently. Overall, we believe the weakness in economic fundamentals in China, the monetary policy easing and the backdrop of the relatively stable CNY currency will be supportive for CNY bond investors.
When the economy turns around, possibly in the second half of the year, there may be opportunities in the China US dollar-denominated credit markets. Investment grade and high yield spreads in the US and Europe are still very tight compared to China high yield bonds, and this could be the time to consider Chinese high yield securities, in particular property. It’s true that the property market is not out of the woods yet, but with the current market pricing in what we believe to be an unrealistically high 55% default rate, we think valuations are attractive and there are quality companies to choose from for the long-term investor. For investors who are already invested in Asia high yield, a shift into China high yield could be beneficial as a means to express a more pointed exposure.
Over the longer term, we still expect the favorable valuation and risk characteristics of China fixed income to continue to attract global investors. The continued increase of China's weight in global bond indices will serve as a tailwind for the sector over the medium term. Further liberalization of Chinese financial markets should attract new investors as well. In the end, we believe China’s yield story is still an attractive one even though policy is changing and global uncertainties are high. Today’s Chinese sovereign bonds offer a 1-2.5% yield pickup over some major developed market bond markets (UK, Switzerland, Germany, Japan), delivering real yields through low correlations. China high yield credit spreads are at their all-time widest, and the China bond market still presents many investment opportunities.
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