The US will likely have to reverse its policy on raising interest rates this year and return to monetary easing, said CLSA global equity strategist Christopher Wood, who favours Chinese onshore government bonds as a result.
While the US Federal Reserve raised interest rates for the first time in nine years in December and had targeted further hikes this year, the ongoing liquidity problems in corporate bond and equity markets is throwing a spanner in the works, argued Wood yesterday.
He said the rising yield of US junk bonds was causing unexpected liquidity stress that would impact equity markets, as bonds are used as collateral for financing stock investments. Investors will consequently need to dump shares, he added, and such market distress is likely to lead to renewed Fed easing in 2016.
More quantitative easing in the US may provide some reflationary relief in the form of a weaker dollar, Wood noted in his 2016 market outlook report.
As a result, he is “very bullish” on onshore RMB government bonds when it comes to Chinese assets, amid a slowing economy and bearish outlook for mainland equities. “The best thing to invest in China is the 10-year government bond, as the yield is collapsing," said Wood. "My view is it will further collapse."
The 10-year onshore government bond yield had fallen to 2.77% as of yesterday from 3.62% at end-2014, though it is stil much higer than yields in Japan (0.224%) and Germany (0.482%) for government bonds of the same duration.
Fund managers have been bullish on onshore renminbi bonds since the People’s Bank of China cut interest rates in November 2014. The average return of mainland bond mutual funds in 2015 was 10.6%, according to Galaxy Securities.
Certainly, foreign institutions will need to move into the onshore government bond market after the renminbi enters the International Monetary Fund’s special drawing rights (SDR) basket this October.
“I believe the Chinese government is hoping global central banks and sovereign funds will deploy part of their foreign reserves into RMB assets, and the obvious area is Chinese fixed income,” said Wood. He expects onshore bond prices will rally substantially before foreign institutions enter the market in October.
Wood expects A-shares to fall further, but he said a greater concern for foreign investors was the currency. The question of whether China can manage the RMB exchange rate to facilitate a smooth inclusion into the SDR group of reserve currencies is “10 times more important than the Shanghai equity market”, he said.
Despite the fears over yuan devaluation in recent weeks, Wood is relatively optimistic about the Chinese central bank’s ability to manage the shift. The renminbi should eventually stabilise against a trade-weighted currency basket, he noted, particularly when the dollar rally comes to an end.