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The resumption of US-China trade talks combined with a more dovish US Federal Reserve (US Fed) has boosted investor confidence. There was 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 the improved sentiment is the imminent inclusion of Chinese domestic bonds in global indices from April. As Chinese bond markets become more accessible to foreign investors, we believe they are likely to be well supported by easing policy measures, as well as stronger inflows.
Easing trade tensions bring New Year cheer
Since the beginning of 2019, risk-on sentiment has proved positive. After its January meeting, the US Fed met market expectations by announcing it will adopt a less hawkish policy and 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 has also brought hope for an eventual agreement and an end to the US-China friction. China has agreed to expand its purchasing of US goods ahead of further negotiations between the two countries.
Meanwhile, emerging markets recorded four consecutive weeks of fund inflows in January, with the JP Morgan EMBI Global Diversified Index increasing by 3.3% — the best monthly performance since June 2016. Other emerging market assets also benefited from the turnaround in sentiment. The MSCI Emerging Market Equity Index gained 8.7% in January and the MSCI Emerging Market FX Index rose by 2.6%.
China opening presents attractive opportunities
After a difficult 2018, Chinese markets welcomed in the Year of the Pig, an animal that represents luck, wealth, and prosperity. While the country faces headwinds from its deleveraging policies and trade disputes, we see several reasons for investors to consider Chinese government bonds, not least because of their upcoming inclusion in major global indices.
Bloomberg Barclays has already confirmed it will feature Chinese treasury and policy bank bonds in its US$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.
Since early 2016, China has made headway in opening its financial markets to foreign institutional investors as part of a broader strategy to internationalise the renminbi as a payment and investment currency in step with its growing stature in the world economy. The resulting reforms have accelerated the case for accepting China into mainstream bond indices.
China has the third largest bond market in the world, and its inclusion in major bond indices is likely to have a significant impact. If onshore Chinese bonds are included in all fixed income indices, there is potential for around US$420 billion1 in inflows. Local currency Chinese bonds would be the fourth largest currency component of the Bloomberg Barclays Global Aggregate Bond Index after the US dollar, the Euro, and the Japanese yen. Chinese debt would meanwhile represent a significant 6% of the index.2
Investor sentiment will be further raised by the recent decision by Chinese authorities to allow rating agency S&P Global to become the first foreign organisation of its kind to enter the Chinese market and rate domestic bonds.
Enticing prospects for global investors
In an environment still dominated by low sovereign bond yields, Chinese fixed income presents attractive opportunities for global investors, with Chinese government bonds offering a yield premium of around 2% above global treasury bonds, despite yield compression last year.
In addition, with a small foreign investor base, the Chinese bond market has a very low correlation with global bond markets. Chinese bonds have exhibited a correlation of just 0.2 with US Treasury bonds over the past decade, providing potential diversification benefits to core portfolio exposures.
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2 Source: SSGA, Bloomberg Barclays, JP Morgan, as at 31 December 2018.
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