Pivot to China?

To state the obvious, 2022 is testing investors’ nerves. With no asset class seemingly able to help them, is it time to rethink allocations? The diversifiers which worked well between 2008-2021 have generally failed this year, with only cash, commodities, volatility and trend following-strategies bringing any relief to (our) multi-asset portfolios – albeit these tend not to represent a large enough portion of our allocation to turn the tables. Investors’ eyes are being drawn to Chinese bonds: their 3.4% return so far this year¹ seems rather appealing, particularly given it has been a period of rising rates globally. This market is no longer narrow or hard to access for foreign investors, so is there a case for Chinese bonds in multi-asset portfolios? Here is our assessment.

 

Better liquidity, easier access

China has become a major economic power and has issued a lot of bonds in reaching this status. Today, China not only represents the second-largest economy in the world in terms of GDP, but also in terms of fixed-income markets. China's bond market has experienced explosive growth over the past two decades, rising from below USD 1 trillion in 2002 to reach a peak of USD 18 tn in 2022. Interestingly, 64% of these bonds are government bonds, while the rest are corporate debt. Up until recently, the main drawback of Chinese bonds was their accessibility, in line with its stock market and the ‘A-share’ mechanism.

That difficulty has eased considerably, to the point that Chinese bonds today are liquid enough to be incorporated into most standard bond indices and indeed now represent a meaningful portion of many prominent global government bond indices. For instance, Chinese bonds represent close to 10% of the Barclays Global Aggregate Bond Index and close to 5% of the FTSE World Government Bond Index. With past complexity in accessing China's onshore bond market being eased through the ‘Bond Connect’ programme, an increasing number of foreign investors have started to invest. Since the Bond Connect programme’s launch, foreign holders of Chinese bonds have quadrupled from below CNY 1 tn in 2017 to close to CNY 4 tn in 2022.

 

An attractive yield-to-risk ratio

The main reason investors hold bonds is their ability to deliver performance, which over the longer run owes much to their yield. We aim to incorporate Chinese bonds as part of our structural asset allocation, rather than as a tactical play. Taking a very long-term investment horizon, what matters in the end is their real performance and, therefore, their real yield. From that perspective, China's current real yields already stack up well compared to other developed nations.

With inflation red-hot in most developed nations, it is unsurprising to see 10-year real yields (calculated using realised core inflation) to remain resolutely negative. Now, real yield comes with risks: China is on the fringe of becoming a developed economy, but for the moment it remains an emerging one. Figure 1 compares real yields with two credit metrics: credit-agency ratings and debt to GDP, as a simple measure of creditworthiness. From both angles, Chinese bondholders are being rather well paid for the apparent risk they are taking – with one caveat.

From the perspective of fiscal discipline, China has been entertaining a shadow-banking financing system that occupies a grey zone when it comes to the government’s ultimate responsibility towards it. China’s challenging housing situation this year is nothing but an echo of that. Even so, with today’s inflation and yield situation, the long-term risk-reward trade-off for holding Chinese bonds seems positive.

 

FIG 1. Chinese real yields vs credit ratings, and real yields vs debt to GDP

Source: Bloomberg, LOIM. For illustrative purposes only. Past performance is not a reliable indicator of future results.

 

Another source of diversification

A typical sign of a maturing financial market is the general lack of correlation between equities and bonds. We are not saying that equities and bonds will always be diversified with each other, but all things being equal, equities are riskier than bonds and flight-to-quality periods should prompt investors to favour bonds when recessions happen. As of late, Chinese assets have increasingly behaved according to the patterns observed in developed-market assets, rather than emerging-market (EM) assets.

In the case of EMs, equities and bonds are positively correlated as they carry a similar risk: during recessions, EM central banks need to hike rates to maintain the value of their currencies, meaning their equities and bonds tend to decline together.

Since the Covid crisis, when viewed from an equity-bond diversification standpoint, China has shown significant improvement (see figure 2). Between the global financial crisis and the 2020-2022 period, the equity-bond correlation within Chinese assets has decreased on average. What’s more, for prominent developed markets, such as the US and Germany, that correlation has tended to increase recently. From that perspective, the diversification potential of Chinese bonds is very appealing.

 

FIG 2. Equity-bond correlation between regional assets

Source: LOIM, Bloomberg. For illustrative purposes only. Past performance is not a reliable indicator of future results.

 

Simply put, Chinese bonds deserve a place in diversified asset allocations given their yield level and historical diversification effect.

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Macro/Nowcasting Corner

The most recent evolution of our proprietary nowcasting indicators for world growth, world inflation surprises and world monetary policy surprises are designed to keep track of the latest macro drivers making markets tick. Along with them, we wrap up the macro news of the week.

Our nowcasting indicators currently show that:

• Global growth is clearly declining. The US and Eurozone are showing signs of decelerating growth momentum while the most recent data show that this deterioration has further to go. The US is increasingly showing indications that it is entering into a recession
• Inflation surprises will remain positive for the Eurozone but are declining elsewhere and are now non-existent in the US
• Monetary policy is set to remain tight: central bankers are likely to be more hawkish than expected

 

World Growth Nowcaster: Long-Term (left) and Recent Evolution (right)

 

World Inflation Nowcaster: Long-Term (left) and Recent Evolution (right)

 

World Monetary Policy Nowcaster: Long-Term (left) and Recent Evolution (right)

Reading note: LOIM’s nowcasting indicator gather economic indicators in a point-in-time manner in order to measure the likelihood of a given macro risk – growth, inflation surprises and monetary policy surprises. The nowcaster varies between 0% (low growth, low inflation surprises and dovish monetary policy) and 100% (the high growth, high inflation surprises and hawkish monetary policy).