What is the outlook for China onshore bonds?

With continued geopolitical tension, an economy recovering from Covid lockdowns and an evolving policy landscape, many investors are curious as to the outlook for China onshore bonds. In this post we outline our near-term outlook and focus on the following topics:

  • China's aggregate demand should recover gradually in H2
  • USDCNY could trade to 6.30 by year-end
  • EURCNY could end the year unchanged
  • The bottom line

We maintain a positive outlook for the China onshore bonds for H2 2022: with aggregate demand likely to remain weak, bond yields should be heavy with low volatility. We see USDCNY trading lower into year-end. We suspect EURCNY might exhibit a more neutral trend than USDCNY, because of how low EURUSD already is now.

China 10yr benchmark yield: Historic 5yrs

2022 08 17 CN 10yr BM

FX Pairs: Historic 5yrs

2022 08 17 FX

Past performance is not a reliable indicator of future returns. Source: Eurizon SLJ Capital & refinitiv Eikon as of 17 August 2022.

China’s aggregate demand should recover gradually in H2

China’s economic growth slowed from 8.1% in 2021 to only 2.5% in H1 2022, due primarily to the Covid lockdowns and the protracted struggles that the property sector experienced. In July, consumer confidence remained weak and investors’ sentiment fragile. Despite the targeted fiscal stimulus on infrastructure projects, overall demand growth remained weak. We expect economic growth to gradually recover, along a flattish ‘U-shaped’ trajectory, supported by additional policy stimulus, an improvement in the Covid situation, as well as regulatory easing to prevent the property sector from imploding. While incremental growth in H2 should be meaningfully stronger than in H1, we estimate nominal GDP growth to be no more than 6 percent, substantially below an average of 10 percent in the three years ending in 2019.

Against this macro backdrop, Chinese bonds ought to fare much better than equities, as they have done so since last summer. This is because the public sector (the government and the State-Owned Enterprises) account for 98 percent of all China onshore bonds while they account for 35 percent of all Chinese equities. (In comparison, the figures are 70 percent and 0 percent, respective, for the US.) The parts of the Chinese economy that are struggling are concentrated in the private sector, and in Beijing’s regulatory campaign last summer, not one of the targets was a State Owned Enterprise. Thus, when thinking about the prospective performances of bonds and equities in China, this consideration of the composition of the issuers is critical. We think this explains why, against the slew of poor headline news on China, Chinese local currency bonds have remained bid, with minimal volatility, even though some Chinese dollar bonds and Chinese equities had poorer performances accompanied by higher volatility. In any case, in the coming months, as long as the economic recovery is a flattish U-shaped trajectory, this downward bias on Chinese bond yields ought to persist, in our view, and in turn enhancing the return of China onshore bonds.

USDCNY could trade to 6.30 by year-end

We never subscribed to the occasionally popular view that the RMB would collapse under the weight of the negative geopolitical attention or the need for China to competitively devalue the currency. Instead, we have had the view that the Chinese RMB is one of the best currencies in the world, due to the structural fundamentals of the Chinese economy, its export competitiveness, and the prudence of the PBOC’s policies. Inflation has run much lower in China relative to most of the developed economies. This ought to enhance China’s competitiveness and further flatter its exports and the external balance. China’s current account (C/A) surplus totalled some USD169 billion in H1 2022 (annual run rate of a massive USD350 billion), compared to USD112 billion in H1 2021, against the overwhelming consensus earlier this year of weakening demand for Chinese exports. We believe that, as soon as the dollar starts to turn to reflect peak FFR, the Chinese exporters currently hoarding USDs will sell them and buy RMB, leading to a fall in USDCNY. We see 6.30 by year end.

EURCNY could end the year unchanged

EURCNY is the product of USDCNY and EURUSD. EURUSD, we think, could be weighed down in the coming weeks by the Russian gas embargo but downside risks might be limited given how undervalued the EUR already is. A bounce in this cross later this year is, in our view, equally probable. Thus, we do not assume there to be a bias one way or another in EURUSD in H2 2022.

Bottom line

As the chart below shows, despite the disturbing headlines (geopolitical, economic, and policies) on China, China onshore bonds have been by far the best performing asset class year-to-date, excluding commodities. While we expect global equities to recover somewhat in H2 2022, for China onshore bonds, from the perspective of GBP & EUR-based investors, the outlook for H2 remains quite positive. The underlying should perform better than the FX component, we suspect. In fact, the worse the economic and geopolitical headlines for China, the better the outlook for China onshore bonds, just last the recent quarters.

Cross asset performance: Year to date

2022 08 17 cross asset ytd

Past performance is not a reliable indicator of future returns. Source: Eurizon SLJ Capital & Morningstar Direct as at 31 July 2022. Monthly returns in GBP. China Onshore Bonds = Bloomberg China Aggregate TR USD, US Bonds = Bloomberg US Agg Bond TR EUR, US Equity = MSCI USA GR EUR, EM Local Bonds = JPM GBI-EM Global Diversified TR EUR, Japan Equity = MSCI Japan GR EUR, Europe Equity = MSCI Europe GR EUR, EM Equity = MSCI EM GR EUR, EU Bonds = Bloomberg Euro Aggregate TR GBP, EM HC Bonds = JPM EMBI Global Diversified TR EUR, China Equity = MSCI China A Onshore GR EUR.

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    Sources

    Source: Eurizon SLJ Capital, Refinitiv Eikon & Bloomberg

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    None of the contents of this document should be understood as constituting research on investment matters, or as a recommendations, advice or suggestions, implicit or explicit, with respect to an investment strategy involving the financial instruments discussed, or the issuers of the financial instruments, nor as a solicitation or offer, nor as consulting on investment matters, of a legal, fiscal, or other nature. All the companies of the Intesa Sanpaolo Group, its administrators, representatives, or employees, decline any responsibility (fault-based or otherwise) deriving from indirect damages potentially caused by the use of this communication or its contents, or in any case deriving in relation to this document, nor may they be consequently held liable for any of the above. The information provided and the opinions contained in this document are based on sources considered reliable and in good faith. However no declaration or guarantee is offered by Eurizon SLJ Capital Limited, explicitly or implicitly, on the accuracy, exhaustiveness and correctness of the information, and there is no guarantee that results, or any other future events, will be compatible with the opinions, forecasts, or estimates contained herein.

    Views accurate as at the time of publication. Opinions expressed by the authors are their own and do not necessarily reflect those of Eurizon SLJ Capital Limited, Eurizon Capital SGR or the Intesa Sanpaolo Group.
    The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.

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