By Ken Peng
Head - Asia Investment Strategy
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We see China's monetary, regulatory, and fiscal policy easing as a positive catalyst for its bond and equity markets.
Trade developments remain difficult to predict, but China has shown its ability to deploy policy to stop the erosion of confidence. Absent a severe and unresolved trade war escalation, we believe that the combination of a cheaper currency and significant domestic policy easing could restore market sentiment in Chinese equities and bonds.
Trade risks escalated after the US threatened to increase the tariff rate from 10% to 25% on another $200bn of Chinese products, which was then followed by China's release of a list of 5,207 items of US products on which to tariff 5-25%. Clearly, China's imports from the US ($188bn for goods and services in 2017) is much smaller than US imports from China ($524bn). China's retaliation may include all imports, as well as non-tariff measures. These potential retaliations would include US exports of energy and possibly IT products, such as smartphones and chips. Alternative measures may include possible actions against American businesses in China. These could add pressure on the current market weakness.
China's other response to the trade conflict is to allow the market to take the Chinese currency weaker, with minimal intervention to defend the currency up until recently. The CNY had depreciated 9% versus the USD since April which would have offset most of the effects of the 10% tariff. If this tariff becomes 25%, there could be notable additional depreciation of the Chinese currency. President Trump is correct to suggest that a weaker currency is necessary to win a trade war, but US threats have shaken market confidence in EM, which is strengthening the USD as a haven currency.
Fortunately, this round of CNY depreciation has had much less spill over effect than in 2015-16. First, China's capital controls are much more effective. More importantly, policymakers have allowed for cheaper FX hedging. In 2015, the policy reaction to sharp depreciation was to drain onshore liquidity to make shorting the RMB more expensive. But this exacerbated investor selloff of Chinese assets because they do not have a cost effective way to hedge FX risk. The liquidity tightening and weaker sentiment doubled the damage to the economy.
This time, the People's Bank of China (PBOC) eased liquidity conditions and allowed forward points to fall. Though the 20% required reserves were reinstated on FX forwards, the cost of hedging is still at the cheapest since 2011, before depreciation expectations started. Holders of CNY bonds can hedge away FX risk and retain most of the extra yield that the Chinese government bond has over US treasury (UST). This spread, net of hedging costs, is close to the highest in over four years.
This cost effective hedge reduced the need for investors and corporates to sell down otherwise viable bond and equity positions. Foreign inflows to the onshore bond market have reached a record high of RM87bn in June 2018, a sharp contrast to the outflows in Jan 2016. A potential side effect if the PBOC is taking an interventionist approach now is that it could hurt other currencies like in 2015-16, if trade or other concerns escalate further and the market may go to short other high beta currencies.
A weaker currency is a key condition for absorbing a trade shock. This is the case for most EMs through history. In the past, Chinese policymakers' first reaction to external shocks was to fix the exchange rate with the USD to maintain stability, while most other currencies decline. This makes Chinese assets more expensive even if their local currency value has fallen. Bull markets (except the margin driven bubble of 2014-15) tend to start when this distortion ends, typically when the USD starts to weaken.
This time, by limiting intervention, the CNY does not have accumulated overvaluation to correct. Aside from additional trade risks, the exchange rate is not a hindrance to the recovery in equities and bonds. With limited capital outflows, currency depreciation is just adding to the policy easing and creating incentives for global investors to capture China's longer term growth potential at a cheaper price. As we've noted previously, CSI 300 index of A-shares have fallen 19% YTD, or 23% decline in USD terms, and 10.1x forward PE ratio.
Overall, China's policy response to this round of domestic and external risks is far more calm and systematic than in the past. Domestic risks are likely already contained by recent policy actions in monetary, regulatory and fiscal channels, each to address specific misalignments in the economy. In case these measures are still insufficient, there is also more space for further easing.
As a result, we believe that despite continued trade risks, the Chinese bond and equity markets may already be priced cheap enough to generate positive returns in our 12-18 month investment horizon, with longer-term gains beyond.