The Call-Up

John Leiper – Chief Investment Officer – 29th September 2020

Last week the FTSE Russell decided to include Chinese government bonds in its flagship World Government Bond Index (WGBI). The decision follows similar moves, from JP Morgan and Bloomberg, and a failed attempt to do so just one year prior which resulted in a number of reforms, to increase accessibility and currency trading options, that ultimately paved the way for benchmark admission.

Inclusion will officially commence on October 2021 but the decision, which was widely expected, has already catalysed early inflows.

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Despite being the world’s second largest bond market, weightings across bond indices are not reflective of China’s existing, and growing, economic importance. As a result, foreign ownership of Chinese bonds (less than 3%, or $410 billion of the $16 trillion market) should increase significantly. One estimate, from Goldman Sachs, predicts an additional $140 billion of inflows over the 12-month phase-in period based on $2.5 trillion of assets tracking the WGBI.

The main outcome from this decision is that China will increasingly be thought of as more of a developed market country, than an emerging one. As a result, the higher yield will increasingly attract the attention of global asset allocators.

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As shown in the chart below, on a dynamic basis China’s yield premium over US debt is back near record highs, at around 240 basis points. Given the meagre yield available across developed markets, this is likely to attract large and persistent inflows from US Treasuries, European markets and Japanese notes.

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Investors are well compensated given China’s lower debt to GDP ratio (versus the US and many highly indebted European countries) and solid credit rating thanks to its steadily managed foreign reserves. Further, Chinese government bonds proved remarkably resilient during the recent market turmoil, attracting safe haven flows. Setting aside supply dynamics, the key risk to investing in Chinese bonds is political and relates to prior attempts to force US investment companies to divest holdings in Chinese companies. If that proved controversial, then the prospect of US investors investing directly in the Chinese state could prove abhorrent.

Earlier this month we increased our existing exposure to the iShares China CNY Bond ETF, taking our total allocation within fixed income to approximately 12%. Since the 31st July, this position has outperformed an equivalent index of emerging market local currency government bonds, priced in GBP, by 7%.

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This recent performance differential can largely be explained by currency. China’s economy has proven remarkably resilient to the virus and recovered far quicker than competitor nations. Whilst the Federal Reserve has resorted to aggressive monetary policy stimulus, Beijing has refrained from such action which has bolstered China’s current account standing, attracting inflows which have supported the currency. Post index inclusion the Chinese renminbi will be the fourth largest currency in the WGBI index after the US dollar, euro and Japanese yen and we expect foreign investor participation to provide solid ongoing support.     

In a financial system awash with liquidity, fundamentals arguably matter less than they should, but it is interesting to note we are now seeing a clear differentiation across emerging market currencies, with a preference for strong sovereign balance sheets. Over the last three months, of the nine EM countries with current account surpluses (shown below), all but one, Russia, have seen their currencies rise in value against the US dollar. Meanwhile, countries with weak balance sheets, that have also bore the brunt of the pandemic, such as Brazil and Turkey, have been particularly hard hit.

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Within emerging markets we retain a preference for ‘quality’ currencies with unhedged exposure to the renminbi (via government bonds and equities), the South Korean Won and Taiwanese Dollar, all of which appear in the top right quadrant of the chart.  

However, depending on the progression of the virus, we remain open to the possibility of a broader economic recovery, improvement in risk sentiment and subsequent rotation into cyclical investment opportunities. Such opportunities exist within the broader emerging market currency index which continues to lag developed market peers, and certain East Asian currencies, by around 15% versus the US dollar.

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As an outlier, the Russian ruble stands out as a potential beneficiary from the aforementioned scenario and Russia’s energy dominated equity market could also benefit from a gradual rise in oil demand, and prices, in the post pandemic world.

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This investment Blog is published and provided for informational purposes only. The information in the Blog constitutes the author’s own opinions. None of the information contained in the Blog constitutes a recommendation that any particular investment strategy is suitable for any specific person. Source of data: Bloomberg, Tavistock Wealth Limited unless otherwise stated.  

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