China fixed income: sailing into a year of reopening and policy pivots

Against a volatile backdrop, onshore China bonds managed to outperform most of their global peers in 2022 due to the liquidity buffer the asset class offers, lower correlation with other global fixed-income markets, and positive real yields. Indeed, easing has been the main tune in regard to Mainland China’s monetary policy in 2022. Offshore China bonds, however, were dictated by another set of dynamics: They were notably affected by ongoing issues in the property sector, resulting in the sharp correction seen among high-yield names within the space.

Key highlights of market performance¹:

• On a year-to-date basis, 10-year China government bond (CGB) yield closed marginally higher at 2.87%, up from 2.78%. Given the onshore market's abundant liquidity, yield levels stayed rangebound between 2.95% and 2.62%.
• Amid a hawkish U.S. Federal Reserve (Fed) and broad risk aversion, the Chinese yuan (CNY) posted a full-year decline of 7.86% against the U.S. dollar (USD). In the fourth quarter, the CNY passed the peak of foreign outflows, which saw the CNY recover to 6.90 against the USD from 7.12 at the beginning of the quarter.
• China USD credit posted -10.45% returns (using J.P. Morgan China Total Return Index as a proxy) during the year owing to higher U.S. Treasury yields and wider credit spreads, although that’s been partially offset by positive carry. Uncertainty about selected property developers’ ability to service their payments or refinance ahead of maturity continued to pressure Chinese property sector bonds.

Toward the fourth quarter of 2022, a major shift to ease COVID-19 restrictions and supportive property sector policies boosted market sentiment. In our view, these measures should help the sector find a bottom over the next 12 to 18 months. 

Mainland China’s long-awaited reopening materializes—going on the offensive in 2023

Moving into 2023, our view on the asset class has become more constructive relative to the defensive stance we assumed during the previous year. Indeed, as soon as Mainland China announced a double pivot in the country’s COVID-19 and property sector policies, we started to adopt a more offensive stance in the fourth quarter of 2022:

1. Mainland China’s reopening of its borders and the loosening of COVID-19 measures
2. The introduction of strong policy “bazooka” with an all-in effort to boost economic growth
3. Adopting an all-in approach to support the property sector to achieve a sustained recovery in the real estate space
4. The Fed is expected to gradually slow down its rate hikes or pause in 2023

We believe a more offensive stance will continue to benefit from these macro and policy tailwinds operating throughout the fourth quarter of 2022 into the new year, as markets haven’t fully priced in the positive factors and the potential of an improvement in underlying fundamentals. Moreover, the advanced stage of reopening of some Asian economies continues to be a positive factor and one that hasn’t been fully priced in.

After announcing the decision to fine-tune the country’s zero-COVID policies (20 measures) in November 2022, late December saw Mainland China abolish hotel quarantine and on-arrival PCR testing requirements for inbound travelers from January 8, 2023. On December 27, 2022, the government further announced that it would resume issuing tourist and business visas for Chinese mainland residents visiting Hong Kong and begin to reopen the country’s sea and land ports.

We believe that China’s COVID-19 policy U-turn paves the way for a shift to a strategy of living with the virus, which sets the stage for resuming both inbound and outbound travels in the first half of 2023. Whether the return to normality will be gradual or abrupt is still subject to the surge of infections and their potential impact on supply chains. At the time of writing, the real growth rate of Mainland China’s GDP for 2022 is forecast to be 3.0%, followed by 4.8% in 2023, and 5.0% in 2024.²

Our rate, currency, and credit outlook

As the market now expects improved economic growth in Mainland China that may lead to a moderate rebound in inflationary pressures and higher onshore rates, we could see the onshore yield curve steepen. At the same time, the CNY might strengthen in the foreign exchange market. Therefore, having an underweight exposure in duration in our onshore CNY bond portfolios should help buffer the impact of rising rates.

Turning to the foreign exchange space, the CNY will likely benefit from the domestic economic recovery, more substantial policy stimulus, and a USD that may be peaking in value. Higher rates would also attract portfolio flows to the onshore markets as the interest-rate differential between the CNY and USD should narrow, providing support to the renminbi. Therefore, we believe that the outlook for the renminbi has become more constructive, and investors could potentially benefit from a reduction of CNY hedges against the USD.

Regarding different segments of China bonds in the onshore market, we maintain a relatively cautious view of corporate credit and bank capital bonds as valuations appear unattractive. We’re more neutral on policy bank bonds and CGBs. Simultaneously, as investors seek to benefit from the country’s reopening, there’s the potential to increase their offshore China USD-denominated high-yield exposure due to the latter’s attractive valuations. From a sector perspective, we believe it makes sense to identify opportunities to selectively add higher-quality property developers, especially state-owned enterprise developers that benefit from greater state support. We also believe adding some exposure to internet and technology names that are well positioned to gain from a domestic recovery could make sense..

Currently, the opportunity set for sustainable investing remains predominantly in the offshore USD market; however, once the onshore green-bond market develops further and becomes more scalable, it could offer multiple investment possibilities.

There could be more targeted support for the real estate sector

In the new year, we expect more supportive measures for the property sector following the financing support announced (widely known as the second arrow) in November 2022. Significantly, in early January, the People’s Bank of China (PBoC) and the China Banking and Insurance Regulatory Commission announced a bold new initiative to establish a new mortgage rate adjustment framework for first-time home buyers when housing prices drop. This will likely result in a material decline in these buyers’ mortgage rates and could be supportive for the property sector. At the same time, market headlines suggest that China is considering relaxing its stringent three red lines property rules for some developers. If implemented, this would represent a significant policy shift and will likely build investor confidence in the sector.

Indeed, the recovery story depends on how quickly developers can reinstate cash flow, but as the economy reopens, there may be an uptick in household incomes that, in turn, should result in increased property transactions. A headwind to note is the slowdown in the United States and Europe could have a knock-on effect on Mainland China’s export manufacturing sector, which may affect employment levels. Overall, the recovery should be quite meaningful in the second half of 2023 but possibly less robust (a u-shaped rebound) than the post-COVID-19 upturn (a v-shaped rebound) in 2020.

Adopting a pragmatic approach with fiscal stimulus

We believe the government and policymakers will be mindful of the aforementioned factors and will likely observe how the reopening plays out before considering further fiscal stimulus. In terms of official benchmark interest rates, these should remain on hold with no changes expected until late 2023, which could coincide with the Fed reaching its terminal interest rate. Indeed, we may have already reached the maximum interest-rate policy differential between the PBoC and the Fed. As such, as Mainland China reopens and the Fed is in the latter stages of its tightening cycle, currency depreciation pressures have probably peaked. As we have detailed previously, China bonds can serve as a potentially resilient risk diversifier due to the asset class’s low correlation to other parts of the global fixed-income market, decent interest-rate carry (on a hedged basis), and abundant onshore liquidity.

1 Bloomberg, data as of December 28, 2022. USD/CNY was as high as 7.3050 on October 31, 2022, and depreciated to 6.9501 as of December 28, 2022. 2 Based on Bloomberg consensus forecasts. 3 We established our onshore China bond performance track record in 2010.