Kheng-Siang Ng

A resumption of US-China trade talks and a more dovish US Federal Reserve (US Fed) has combined to boost investor confidence. This in turn, triggered a strong rally in risk assets throughout January and the first half of February, with emerging market equities, debt and currencies posting notable gains.

Underscoring this improving sentiment is the imminent inclusion of Chinese domestic bonds in global indexes from April 2019. As Chinese bond markets become more accessible for foreign investors, we believe they are likely to be well supported by easing policy measures, as well as stronger inflows. 

2019 BEGAN ON A BRIGHT NOTE

In the year to date (and at time of writing), risk-on sentiment was positive. In a statement following its January meeting, the US Fed met market expectations of a less hawkish policy this year, announcing that the Federal Open Market Committee “will be patient as it determines what future adjustments to the target range for the federal funds rate may be appropriate.”

The resumption of trade talks also brought hopes of progress towards an agreement, which could potentially end the US-China trade spat. China has agreed to expand purchases of US goods, ahead of further planned negotiations between the two countries.

Emerging markets recorded four consecutive weeks of fund inflows in January. The JP Morgan EMBI Global Diversified Index increased by 3.3% in January, the best monthly performance since June 2016.

Other emerging market assets also benefited from the turn in sentiment since last year, with the MSCI Emerging Market Equity Index gaining 8.7% in January, while the MSCI Emerging Market FX Index rose by 2.6%.

A NEW YEAR FOR CHINESE BOND MARKETS

After a difficult 2018, China still faces headwinds from its deleveraging process and the trade dispute with the US, but we see several reasons for investors to consider Chinese government bonds, not the least being their upcoming inclusion in major global indices.    

Bloomberg Barclays has confirmed that it will feature Chinese treasury and policy bank bonds in its $54 trillion Global Aggregate Bond Index from April 2019, while JP Morgan is evaluating the admittance of Chinese treasury bonds in its flagship Local Currency Emerging Market Index.  

China has had a deliberate policy of opening up its financial markets to foreign institutional investors since 2016. This is part of a broader strategy to internationalise the renminbi as a payment and investment currency in line with its growing stature in the global economy. As a result, these reforms have accelerated the case for the acceptance of China into mainstream bond indexes.

Since China has the third-largest bond market in the world, its inclusion in major bond indexes is likely to have a significant impact. 

If onshore Chinese bonds are included in all fixed income indexes, there is potential for around $420 billion1 of inflows. In fact, local currency Chinese bonds would be the fourth largest currency component of the Bloomberg Barclays Global Aggregate Bond Index, following the US dollar, the Euro and the Japanese yen. Chinese debt would also represent a significant 6% of the index2.

Investor sentiment towards the country will be further encouraged as rating agency S&P Global was recently given the green light by Chinese authorities to become the first foreign organisation of its kind to gain entry into the Chinese market to rate domestic bonds.

CHINA BOND BENEFITS

Chinese fixed income offers a number of appealing factors for global investors. In an environment still dominated by low sovereign bond yields, Chinese government bonds present an attractive yield premium of around 2% above those of global treasury bonds, despite the yield compression in 2018.

In addition, with a small foreign investor base, the Chinese bond market has a very low correlation with global bond markets, recording a correlation of just 0.2 with US Treasury bonds over the past decade. Since Chinese bonds have a low correlation with core fixed income asset classes, they may provide diversification benefits to investors’ portfolios.

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1. Source: State Street Global Advisors estimates using the Barclays Global Aggregate, JP Morgan GBI-EM and FTSE Russell World indices and based on the assumption that active managers will buy stocks in anticipation of index flows.

2. Source: State Street Global Advisors, Bloomberg Barclays, JP Morgan, as at 31 December 2018.

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