At the beginning of the Chinese New Year, AsianInvestor’s Year of the Pig outlook predicted that the China-US trade war would intensify – and it did.
Towards the end of the first half, some of the shocks of the trade war have been priced in, but tariffs from both countries on each other’s goods are inflicting long-term effects on their economies. Further trade talks were scheduled at the end of June, before the G20 meeting, but there’s no guarantee that US president Donald Trump and China’s president Xi Jinping will reconcile.
“If there isn’t a positive outcome from the G20, we may go into a sharp correction,” said Francois Perrin, a senior portfolio manager with Hong Kong-based firm East Capital.
In addition, factors such as worries over retaliation from the Chinese authorities on foreign investments, a slowing Chinese economy and softening outlook on US’s inflation expectation could shake investors’ general sentiment. Investors with onshore investments in China, are having to consider what factors could have the most impact on investments in China and, most importantly, how they can guard against potential risks.
AsianInvestor asked eight industry professionals to share their thoughts.
The following extracts have been edited for brevity and clarity.
Louis Luo, senior investment manager – multi-asset investing, Asia Pacific
Aberdeen Standard Investments
Chinese financial markets will live with two main sources of uncertainty in coming years. Externally, an escalating economic rivalry with the US including, but not limited to, trade conflict. Internally, policymakers’ deleveraging efforts to contain a peaking credit cycle while orchestrating a gradual slowdown in growth.
Some segments will face higher pressure than others. In the equity market, companies heavily reliant on external demand and so exposed to disruption in the global supply chain could underperform. Within fixed income, we could see rising default rates and widening spreads for low quality corporate credit and small financial institutions with weak balance sheets. Meanwhile, the twin forces of a narrowing trade surplus and converging interest rates with the developed world are likely to generate greater two-way volatility for the renminbi. However, on the flipside, continued financial market liberalisation should hasten structural inflows of capital.
Navigating China’s domestic capital markets requires a rigorous investment process comprising several layers of decision-making. Diversification and dynamic allocation across asset classes as well as investment strategies can reduce exposure to a single tail risk.
For example, unlike most emerging market bonds, China government bonds tend to be negatively correlated with its equity market given dominant domestic holdings, adding great diversification benefit. When it comes to choosing securities, high-quality companies that benefit from long-term domestic economic growth will offer greater resilience in adverse market conditions. Last but not least, a robust risk management process – particularly one incorporating prudent use of derivatives (futures, options and FX forwards) – can help investors to hedge against short-term shocks, and even capitalise on fresh bouts of volatility.
Roger Merz, head of mtx and portfolio manager
Vontobel Asset Management
Trade tensions remain the biggest risk factor for Chinese equities. Investors were probably a bit too sanguine regarding the outcome of negotiations between the US and China at the beginning of the year. This optimism fired up financial markets, despite ongoing negative earnings-per-share revisions – analyst have lowered their earnings forecasts by 10% year-to-date.
Trade tensions are likely to continue for months or even years, the longer the uncertainty lasts, the bigger the impact on company fundamentals will be. Chinese shares may be down but not out, so now is a good time to take a closer look.
We always love to see action from up close. Storms may rage, but unless they have a noticeable impact on the companies we follow, we aren’t overly worried. Therefore, despite the escalating trade row between Washington and Beijing, our portfolios remain unchanged for now. We believe there is currently no reason to take out risk, or decrease the weighting of emerging-market companies.
The recent correction in emerging-market equities might also be an opportunity to start looking at high-quality stocks again. This may be a sound strategy to avoid being drawn into the fight between the US and China.
Alexander Cousley, investment strategy analyst
Of course, the biggest factor for market sentiment at mid-year remains the trade environment with the US, which has deteriorated in the last couple of months. Our base case is still that a deal is reached eventually, however the path towards that deal is likely to create further bouts of volatility through the year.
However, there are a couple of positive catalysts that we are closely watching. Firstly, any additional signs of stimulus from the Chinese government, whether that comes from monetary and/or fiscal policy (and we would point to recent People’s Bank of China commentary that they were ready to add support if needed). Additionally, we are due to see more inflows coming into the Chinese mainland equity market with MSCI raising the proportion of mainland shares in their indices.
There are also inflows into government and ‘policy bank’ bonds, due to the inclusion of Chinese bonds into the Bloomberg Barclays Global Aggregate Index. Fixed income investors should pay close attention to default rates, which have been rising over the last 12 months.
The most prudent way to guard against the risks is to ensure that exposure to Chinese investments is part of a diversified, multi asset portfolio. This will enable investors to weather the volatility that could arise from further trade escalation.
Paul Hsiao, economist, global economic strategy
I would think export and tech-oriented countries in China are particularly sensitive to any risk stemming from the US / China trade conflict.
From a fundamental perspective, the domestic economy looked set to rebound in the first quarter – positive for broader Chinese equities. That narrative was upended in early May when the Trump administration increased the effective tariff rate on Chinese goods and banned using technology made by Huawei.
That hurt Chinese equities but especially Chinese technology companies and exporters even with loosening policies from the government. Dynamics in trade policy are hard to anticipate from the US side, and there remains a considerable amount of risk for those equity sectors going into the second half of the year.
We still are quite optimistic about the Asian growth story. Asia is the world’s fastest-growing region, and even through the trade conflict, we see many companies are thinking of keeping many of their production facilities in Asia because of the lower cost of capital and skilled workforce. We are also positive on emerging market local currency debt, which benefits from both improving fundamentals and less pressure from the US dollar as the Federal Reserve considers cutting rates.
George Efstathopoulos, portfolio manager
We see two major downside risks to China assets; the trade war with the US and the slowdown in domestic economic activity. The first issue is a more immediate worry for markets. We think the first-order impact on Chinese GDP growth from the current set of tariffs is manageable, but the situation remains fluid and so requires constant reassessment.
Importantly, policymakers have exceeded expectations on providing monetary and fiscal support to the economy and this should help stabilise activity in the second half of this year. Developments regarding these issues will play out in the currency markets first, but we anticipate government support for the renminbi would limit losses from here in a downside scenario.
Investors taking an active approach and basing their decisions primarily on fundamental factors should be well placed to endure the short-term market storms caused by the US trade war. A long investment horizon will also help, because it seems the issue is here to stay and will likely cause plenty of ups and downs in markets for the foreseeable future.
The current negative sentiment warrants a defensive stance to renminbi risk and some exposure to local governments bonds, where we expect there is still some upside to prices in the short term. However, there could be opportunities for investors to add China risk if macroeconomic fundamentals begin to improve. We still like China high yield bonds as the government pivots towards supporting the financing conditions of private companies.
Paul Sandhu, head of multi-asset quant solutions, Asia Pacific
BNP Paribas Asset Management
Over the past few months the US-China trade negotiation has become one of the central themes driving emerging market and specifically China Investment. Supported by optimism around the trade talks and also renewed interest in emerging markets overall, China equities and bonds enjoyed a significant move upwards during the first part of this year. However, volatility has soon returned over the last month, depressing the equity market and widening the spread for China corporate bonds.
I see two key risks emerging as a consequence of the tenuous trade negotiation cycle we are in. The first is the weakening of the renminbi – as the trade war intensifies, the probability that we move above the Rmb7 [to the US dollar] level market increases, which will hit portfolios hard.
The second is the heightened level of tail risk. The main contributor of the tail risk is that as the cross market (US – China) become less correlated as they are, the asset classes within the respective markets become more correlated. For example, the correlations between equities and credit has increased significantly. This increased correlation is going to be more significant in a relatively closed and concentrated market such as China.
Diversification and tail hedging are the only two real ways to mitigate tail risk. I believe investors should be considering investment in US dollar denominated bonds from China issuers. This allows for exposure to China credit without the currency depreciation risk. For China equity my advice would be to hedge the downside risk using a derivative strategy around a correlated and/or replicating China index. As derivative hedging is still relatively cheap, this gives investors an efficient way to still participate in the market, but cover the downside.
Tai Hui, chief market strategist for Asia Pacific
JP Morgan Asset Management
A change in onshore investor and business sentiment due to trade tension with the US is a key factor to watch for in China’s equity market. Even though overseas revenue for onshore listed companies is modest (around 20%), the trade war between the US and China in the past year has dampened corporate investment confidence, as well as retail investors’ confidence on investing in risk assets.
As the US-China economic relationship can still blow hot and cold, investors may choose to stay on the sidelines. We think it’s important to think through the short term noise and focus on long-term structural stories, such as China’s growing demand for financial services, healthcare, education and entertainment. This would require more in-depth understanding of domestic market dynamics, including identifying some of the up and coming names that might be less well known to international investors.
In contrast, the bond market may see better support as China’s central bank stands ready to release more liquidity in order to maintain growth stability. Not only would this benefit government bonds and quasi-sovereign entities, companies with weak balance sheets could also potentially benefit. These companies would be seen as having a better chance of obtaining liquidity and servicing their debt.
Investors may also need to be ready to accept higher credit risk in order to generate income. It is understandable that international investors may worry about market liquidity and capital restrictions. The latter issue is now being addressed by the development of the Bond Connect programme.
Tuan Huynh, chief investment officer, emerging markets
Deutsche Bank Wealth Management
We think foreign investors in China could be affected by three factors. 1) The intensified US-China trade tensions. Higher tariffs could affect the production chain of foreign companies in China, as they are the active participants of the global trade activities. Some foreign companies could consider relocating some of their productions to places outside of China, which could incur more investment costs. 2) The slower Chinese economy. We are more likely to see further growth slowdown in China in the second half of this year, which could in turn affect the revenues and profitability of the foreign companies operating in China. 3) Volatility and potential weakness of the renminbi exchange rate. We could see more volatility in renminbi later this year amid China’s growth slowdown and trade tensions.
Having said that, in the current environment, we think foreign investors could potentially benefit from China’s fiscal and monetary policy easing in the second half, the likely policy deregulations for foreign investments (especially in financial industry) and the government’s import support policies.
In the current late cycle environment, slowing economic growth may increase market volatility. We have the following suggestions. First, we suggest investors reduce tactical equity exposure with tariffs debate causing a bigger impact to global production chain in tech sector; but a lower impact to sector driven by domestic demand.
We would also suggest expanding investment horizon in order to navigate short-term volatility and focus on long-term themes, such as infrastructure, medtech at defensive growth and more cyclical robotics. If investors would like to have exposure in equity for a shorter time frame, we would suggest structured products providing capital protection, and thus lower the risks.
Investors could consider increasing fixed income exposure as a more defensive asset class, such as US short dated treasuries, US investment grade credit, emerging market bonds HC, euro crossover.