Principal Monthly Viewpoints (May 2021)
Q: Principal Asset Management (Asia) Investment Management Team
A: Crystal Chan, Principal Asset Management (Asia) Senior Investment Specialist
Q:Have your views towards China bond market changed as China Huarong was in turmoil?
A: This year, the global bond market has generally declined owing to the upward trend in long-term bond yields, while the overall performance of high-yield bonds has shown relative resilience. This can be attributed to the spread advantage and the relatively high degree of correlation with economic trends. Comparing the high-yield bond markets in major regions, the United States and Europe outperformed Asia with a return of more than 2%. Troubled by domestic liquidity issues and the compounding effect over the delay in announcing the annual financial report by China Huarong - a domestic asset management company, which triggered investor concerns on the company's operations and its financial conditions, these have resulted in the relatively slack performance of China’s high-yield bonds with close to zero year-to-date returns as of mid-May.
China Huarong is one of the four major bad debt banks, and the non-performing asset management industry has a special strategic significance in China's financial system. As of middle of the last year, Huarong’s total debt burden was as high as US$160 billion. Should Huarong encounter any default or debt restructuring, there is an opportunity to trigger systemic risks in the mainland financial system. Considering the scale and complexity of Huarong, it will take some time to completely solve the company's financing problems and reestablish the investor confidence.
It was reported that the state-owned distressed debt manager has been urged by regulators to solve its financial issues on its own. In fact, how to resolve the current situation will reflect the attitude of Chinese policymakers. On the one hand, they have strong motives to avoid any defaults by companies with high debt levels and strategic positions. However, to a certain extent, they also hope to avoid serious widespread defaults causing other state-owned enterprises to eventually require more assistance. For the time being, in consideration of the importance of the industry, we still believe that mainland regulatory authorities will extend a helping hand to assist Huarong to avoid systemic financial risks.
In recent years, a series of debt defaults in China have aroused market attention. Since the beginning of this year alone, there have been a number of risk events, especially in the domestic real estate dollar bond market. Examples include China Fortune Land Development’s and Chongqing Energy’s defaults and Yuzhou Group’s profit warning., in addition to the central government’s tightening of domestic housing financing through China’s “three red lines” and repeated mention of reducing leverage, these have put pressure on China’s bond market.
Data shows that the new domestic and foreign defaults by Chinese companies in the first quarter involved a total of approximately US$15.1 billion in bond principals, setting a new quarterly high according to available statistics since 2014 and a significant increase from the second half of last year. Under macro-policy controls, real estate was the worst-hit for defaults, with a default scale of 27%. During the year, as the central government’s supervision of state-owned enterprise debt becomes more stringent, large-scale corporate defaults may gradually increase in the future, especially for companies with over-rated, high debt pressure, and in less than stellar operating conditions, notably some energy and property companies. On the other hand, as China's economy is leading the recovery from the global pandemic, its monetary policy is close to normalisation. As liquidity tightens, pressure on overall corporate debt repayment fundamentals may increase.
Overall, however, China’s default rate remains low. Based on the issuer’s default rate, the annual default rate for 2021 may range from 1.5% to 2.5%, which is lower than the default rate of 4.66% predicted by Moody's at the beginning of the year for global high-yield companies in the next 12 months. According to the issuer's default rate, even the real estate industry, which accounts for a large proportion of China's bond market, has a default rate lower than the market average. As the worries on Huarong’s default gradually diminish, overall Chinese high-yield bond prices have rebounded from lows by more than 2%, and the impact has gradually faded.
Based on the differences in monetary policies between China and the United States, the interest rate differential between the two countries may linger at a relatively high level, attracting foreign investors to hold RMB assets through increased holdings of Chinese bonds. In this global environment of negative interest rates, the higher yields of RMB bonds still have certain advantages. As international index companies include Chinese government bonds in their benchmark indexes, and the relative valuation of China's high-yield bond market is more attractive than the overall Asian and developed markets, the proportion of foreign investments is expected to steadily grow. When the overall Chinese bond market adjusts due to the increased risk of default by individual companies, investors may consider making corresponding deployments.
Q: With rising inflation expectations, what can be the appropriate investment strategies?
A: The rise in long-term bond yields has moderated entering the second quarter. The yield of the 10-year US Treasury bond has fallen from a high of 1.75% at the end of March to the 1.6% level. With the prospect of large-scale fiscal stimulus, the economy is expected to continue to improve, and long-term bond interest rates may still have further upside this year. Long-term bond yields include real interest rates and inflation expectations. Even if the real interest rate is expected to remain negative, as inflation expectations gradually rise, long-term bond yields may hit a high of 2% or more during the year.
Unlike the situation where bond yields surged in 2013, the rise in bond yields this time is mainly contributed by rising inflation expectations. Inflation expectations may continue to accelerate this year as food and energy prices rise further, the breakeven inflation curve implied that the market expects the average inflation in the coming year will rise to 3.2%, which was higher than the medium and long-term inflation expectations. Despite real interest rates may accelerate with the US economic recovery, the Fed has little chance to alter its policy direction in the short-term, they are more likely to remain negative.
In the process of studying the correlation between different asset classes and inflation, we found that the bond market is more susceptible to inflation than the stock market. Among them, core bond investments such as US Treasury bonds, investment-grade bonds, and mortgage-backed securities have established a negative correlation with rolling 12-month consumer price index (CPI) from 2003 to the present. That means these assets may have negative returns due to rising inflation. In fact, the first quarter return of US sovereign debt was the worst since 1981, citing the results of historical data research.
Therefore, we recommend investors to consider switching from traditional bonds to other bond asset classes. Benefiting from spreads and the high correlation to an economic recovery, high-yield bonds may outperform because of rising inflation, especially low duration high-yield bonds, which may reduce the sensitivity to changes in interest rates. Investors may also consider switching to preferred securities that also provide potential stable returns. Preferred securities, which are a hybrid of stocks and bonds, are mainly issued by European and American financial institutions, and their asset quality is generally relatively stable.
For equities, Asia-Pacific stock markets generally have a higher correlation with inflation than global or U.S. stock markets. The Asia-pacific market may continue to attract inflows with relatively attractive fundamentals. Similarly, value stocks generally have a higher correlation with inflation than growth stocks. Since the economy is expected to steadily recover and bond yields may maintain an upward trend, traditional sectors such as energy, finance and industry are likely to continue to benefit from a relatively positive earnings outlook even though current valuations are already at an elevated level.
Q: What is the outlook for the US dollar?
A: In the first quarter of this year, the US dollar moved away from the previous year's decline, climbing from 89 to above 93. However, by the end of April, the dollar index almost returned to its original position, falling back to the 90 level. Some analysts compared the recent weakness of the US dollar with the fall in bond yields. In fact, if you carefully observe the correlation between the Dollar Index and the 10-year US Treasuries in the past ten years, you would realize that there is no absolute correlation between the two, and sometimes the two are even negatively correlated. We believe that the basic factors affecting the US dollar exchange rate have not changed, and it may be difficult for the US dollar to rise significantly in the short-term.
The most important basic factor is inseparable from monetary policy. The US Federal Reserve (Fed) held its April meeting to discuss interest rates. The target interest rate remained unchanged. Towards inflation (core PCE) may rise above 2% in the short-term, the Fed considers this to be transitional in nature. Regarding the job market, Fed Chairman Powell believes that the current number of jobs is still far from before the pandemic. For the economic outlook, risks remain. The result of the interest rate discussion did not bring surprises to the market.
However, the June meeting will be very important. First, the Fed will release its economic forecasts and interest rate dot plots again that month. Compared with last December, at the March interest rate meeting, seven of the eighteen decision-making committee members believed that interest rates would be raised at least once in 2023, two more than three months ago. The market will pay close attention to the decision-making committee’s decision. Second is whether the job market will continue to improve. At the interest rate meeting in April, Powell mentioned that he would observe the job market in "a string of months". By June, there may be enough economic data for the Fed to start a discussion on reducing debt purchases.
With regard to reducing debt purchases, as US economic output returns to pre-epidemic levels, the Fed will have a chance to gradually reduce the rate of debt purchases next year.; Considering that core inflation must continue to be higher than 2% for a longer period of time, for the time being, we are still supportive of the view that the conditions for raising interest rates are premature until the latter part of 2023 or even 2024. We do not think that the Fed will be eager to express a message of policy tightening at the June meeting. Even though there may be more decision-making committee members who think that interest rates will be raised at least once in 2023, the number may not be enough to shake the majority decision.
Another important factor - the large-scale fiscal stimulus measures that happened and in expectations, also means that the fiscal deficit will continue to expand. The US$1.9 trillion relief bill announced in the first quarter alone is expected to increase the US deficit by more than US$1 trillion in the 2021 fiscal year and by more than US$500 billion in the 2022 fiscal year. The deficit as a percentage of GDP may remain at a high level of about 15% this year. Given the drag of the huge deficit, the US dollar may still lack the conditions for a significant rebound.
In the short-term, the US dollar index may find support at the 90 level and fluctuate between 90 and 93. In the medium and long-term, the direction of the US dollar may largely depend on the trend in future monetary policy. The market’s expectations for the Fed’s early interest rate hike have been partially reflected, and what is more important now is when the Fed will express its intention to gradually tighten policy to the market. Unlike the “taper tantrum” in 2013, the current 10-year bond yield is mainly dominated by inflation expectations. The dollar’s weakness may reverse if the real interest rate rises sharply and returns to positive territory.
(Written on 14th May 2021)
Senior Investment Specialist
Principal Asset Management (Asia)