Asia convertible bonds: capturing upside in a strong market

Positive dynamics in the housing and export sectors, plus waning deflationary pressures and better control of local government debt, are clear indicators of an improved outlook for China.
 

1. A clear shift in housing policy 

Considering the impact of lower house prices on consumer sentiment, and a significant drop in the volume of transactions, the government has intervened to support the property market. 

• To encourage home buyers, the Peoples’ Bank of China (PBoC) announced a nationwide cut in the downpayment ratio, the removal of residential mortgage rate floors for first and second homes and a mortgage rate cut to entice buyers back into the market
• Previous policies did not address a vicious cycle; the fragile state of developers led to even weaker primary housing sales, eventually affecting broader consumer demand. Local governments may now buy landbank and residential units back from developers for conversion into affordable housing
• The PBoC is launching a RMB 300 billion (USD 41 bn) relending facility, which is hoped will make RMB 500 bn in commercial bank financing available for property purchases by State Owned Enterprises (SOE) – equivalent to 0.4% of GDP
• We believe that China will be able to avoid the lost decades seen in Japan. The Chinese housing market has already touched the nadir when compared to equivalent real estate crises in other countries (e.g. Spain in 2011). New housing starts are already down almost 70% since the pre-Covid peak 
• Chinese urbanisation is still low compared to Japan (below 65% versus more than 75% in Japan in the 1990s)
• Lastly, demographics are not as bad as feared. The percentage of the population aged between 20 and 34, the potential property buyers, is expected to start expanding from 2029 after a decade of contraction. 
   

2. Strong outlook for export growth 

Investment in manufacturing capacity has been the main target of policy intervention. Due to increasing trade tensions with the US, Beijing has taken steps to ensure autonomy in strategic sectors – e.g. electric vehicles (EVs), solar power and semiconductors. This has started to pay off. Exports have improved since late 2023 and have been largely above consensus so far in Q2 2024. Export growth in May was 7.6% year-on-year versus a 6% consensus estimate. The increase is broad-based and largely driven by restocking in developed markets and an increase in capital expenditure in Asia Pacific. We believe these two tailwinds will remain in place for the near term. 

After Covid, global supply chains evolved from just in time to just in case, leading to above-average inventories. It has taken some time to digest this extra stock, but we believe that the worst is now behind us and we are in the early stages of a new restocking cycle. 

China has increased its global competitiveness via managed currency weakness and has improved the quality of its exported goods³.

3. The worst of the deflationary pressure could be over 

The flip side of the substantial increase in industrial production has been the deflationary effect of weaker demand. As a consequence, Chinese capacity utilisation has gradually decreased since mid- 2021, in particular for strategic industries such as automobiles and electrical equipment. China has already implemented policies to control capacity expansion. In May 2024, rules were drafted to limit lithium battery capacity production, to control the expansion of copper and aluminium production, as well as the key components for semiconductors and EV batteries. 

In 2024, the Chinese government is aiming for 5% GDP growth and the creation of over 12 million new jobs. This is critical, providing jobs for graduates and also as a reflection of China’s shift from a low-cost manufacturing economy towards services and high value-added production capabilities.

We expect ongoing dovish monetary policy to support growth in 2024. For instance, the central bank has cut the five-year prime loan rate that banks and non-bank lenders use as a benchmark for issuing mortgages. The majority of loans in China have a maximum tenor of five years, and are then rolled forward. This rate cut aims to support households by reducing the cost of their mortgage payments to help them weather the property downturn.

4. Local Government Financial Vehicle debt risk is coming under control 

An RMB1.5trn central-local government debt swap was announced in Q4 2023, with Beijing calling for a balance between deleveraging and economic stability in highly indebted regions. The change allows local governments to maintain spending levels whilst alleviating financing risk. With low rates and a positive balance of payments, China has room to finance its debt domestically. Nevertheless, the debt deflation challenge remains alive and well. The overall debt to GDP ratio is set to increase, at least in the short term, with an estimated debt to GDP ratio of 310% in 2024 and 316% in 2025. 

We will closely monitor key policy meetings such as the Third Plenum, where social welfare (social housing, broader pension and healthcare coverage) and rural land reforms will be discussed.

We have outlined how ongoing policy adjustments are adding support, but there are still potential risks that investors in the region should watch. 
 

1.  Rising geopolitical risk 

Tension between the US and China has increased, especially as we commence the countdown to the US presidential election in November. The recent tariff hike by the Biden administration is seen as largely symbolic, covering only 4% of Chinese exports. However, were a blanket tariff to be applied to all Chinese exports, the disruption could be material. There are also lingering concerns over further US action on China-related supply chains from South East Asia, and also from Mexico. Chinese exporters have increasingly been using Mexico as a tariff-free conduit for exports into the US. 

In our view Europe could be a bigger challenge, as the region receives 36% of the new Chinese export trifecta (semiconductors, EVs and solar power-related technology). In terms of global trade between the two regions, the situation is more balanced. In 2023, total European (EU) exports to China were EUR 2.6 trillion versus EUR 3 trn in imports. The EU imports capital goods and equipment from China, and exports consumer goods (luxury, beverages, autos). In the motor vehicle segment, EU exports to China are twice the value of China’s exports to the EU. It is likely that a tariff increase from Europe would be followed by a tit-for-tat riposte from Beijing.

2. Deflation risk 

Reflation policies remain largely unbalanced, with a focus on fixed asset investment although domestic consumption is still weak. Policies which focus only on industrial capacity could backfire, and lead to overcapacity, neutralising government efforts to control production in some sectors. So far, this risk has been mitigated by an improvement in the investment cycle for developed countries, but overall GDP growth remains muted and a deterioration in the macro backdrop for China’s key trading partners could negatively impact the Chinese economy. 

There is also, in our view, a risk that the few faithful long-term investors in China could be disappointed if policies are not carefully executed and do not produce the desired effect. In particular, stabilising the property market will be absolutely key to stimulating domestic consumption.

3. Insufficient policy response 

In response to the housing crisis, the government has been forced to intervene but the measures may not be sufficient (RMB 500 bn) to support prices, which are still on a downward spiral. A more sizable RMB 3-4 trn in government funding may be needed to lower primary inventory to healthier levels. Minutes from the April Politburo meeting suggested that the PBoC may have room for further modest monetary easing (interest rate and Reserve Requirement Ratio cuts) but moves are likely to be limited. 

Bank profitability and balance sheet strength are acting as a firewall to contain the real estate crisis. Lower rates would affect their net interest income. The RMB has fallen against major currencies the past few years and as of May has once again approaching the limit of its fixed trading band against the USD. On one hand, a weaker currency boosts competitiveness and supports exports, but on the other hand it is creating a headwind for direct foreign investment. This could accelerate the dumping of Chinese assets. 

We believe that the PBoC will be able to implement incremental monetary easing but only once the Federal Reserve starts its own rate-cutting cycle in the US. Policy implementation remains frustratingly slow, as usual. For example, the uptake of relending tools for the property sector, in vigour since 2022, has been poor. Only around 4% of the total on offer has been deployed. 

The July meeting of the Politburo should shed more light on the timetable and scope for policy implementation.
 

4. There is potential for other Asian countries 

The growth story for Asia outside of China and Japan has many similarities with the picture for China but its footing is stronger, with a broader base in term of potential performance drivers.

Real growth for trade-dependent economies (Hong Kong, South Korea, Malaysia, Singapore and Taiwan) is benefitting from an upturn in external demand. GDP growth is expected to reach 3.1% in 2024 according to Morgan Stanley forecasts³, but unlike China, where economic growth is driven mainly by exports and fixed asset investment, the drivers for Asian countries are more balanced with private consumption expected to remain steady. 

Growth in South Korea and Taiwan is driven mainly by technology exports including semiconductors and hardware, both of which have shown consistent recovery year-to-date. 

Recent election results in South Korea are likely to provoke a shift towards fiscal expansion in the 2025 budget, with a focus on welfare spending. Moreover, we expect the government to announce tax incentives to encourage companies to participate in the corporate value-up programme, which is similar to recent positive changes in Japan. Inflation has fallen for the past three months, with core inflation now close to 2.2%, almost in-line with the Bank of Korea’s target. Against this moderating inflation outlook, we would expect the Bank of Korea to cut rates once the Federal Reserve announces the first cut in US borrowing costs.

We believe that a mix of light positioning and an ongoing change in sentiment could drive a risky asset rally. China is still under-owned by foreign institutional funds. In aggregate, they are still underweight relative to benchmark (around -2.3%, as estimated by UBS)  with around 25% of active funds having zero China exposure in their portfolios. Also according to UBS⁴, it would require a net purchase of around USD 12 bn of Chinese equities for mutual funds to be in-line with their benchmarks. To put this in perspective, northbound and southbound net volume for Q1 2024 was around USD 26 bn. The latest macro data showed a stabilisation in the regional economy and the recent strong performance of equity and high yield credit markets could be the catalyst for a basis shift in both domestic and foreign investor sentiment.

Bottom-up and top-down valuations are in sync. The Morgan Stanley All Countries Asia ex-Japan equity index (MXASJ) currently trades at around 13x 12-month forward P/E, which is in-line with its 10-year average, however dispersion is relatively high. Taiwan and India appear relatively expensive, but China remains inexpensively valued on both an absolute and relative basis (around 10x 12-month forward P/E and below the 10-year average). In Q1 2024, South Korean companies saw moderate revenue growth, strong margin expansion and robust net profit growth.

From a bottom-up perspective, regional earnings growth is also expected to accelerate, in-line with the potential upswing in global trade. For FY2024e, MXASJ earnings are expected to grow around 24% year-on-year and remain steady in FY2025e at around 16%. 

The strongest growth is expected from the main exporting economies (South Korea, Taiwan and China). In terms of sectors, Technology is likely to be the biggest winner.