From moderate policy tightening to easing: China's bond market continues to provide opportunities

As we approach the end of 2021, our constructive view on the Chinese onshore bond market at the beginning of the year has played out, despite a generally challenging environment for global fixed-income markets due to rising interest rates. Going forward, we believe that China bonds should continue to benefit from several key drivers, namely the call to reengage in policy easing, sustainable currency strength, and the asset classes’ ability to provide diversification benefits for global investors.

China bonds have outperformed other major bond categories (based on the Bloomberg Global Aggregate China Total Return Bond Index), gaining 6.99% over the year to date—as of November 30, 2021, in U.S. dollar (USD) terms. 

Major bond market returns in 2021

Source: Bloomberg, data as of November 30, 2021. It is not possible to invest directly in an index. Past performance does not guarantee future results.

Related market moves:

• The Bloomberg Global Aggregate China Total Return Index has returned 4.20% in local terms (year to date, as of November 30, 2021).
• The onshore renminbi (CNY) has appreciated by approximately 2.60% to 6.36 against the USD over the same period.
• Chinese government bond (CGB) 10-year yields declined by 28 basis points (bps) to 2.86% from the beginning of 2021 to the end of November 2021.
• As U.S. Treasury yields rose, the premium or yield pickup in 10-year CGBs versus U.S. Treasuries also narrowed by 81bps to 1.42%.

China bond premium can attract yield-seeking investors

The strong absolute and relative performance of Chinese bonds in 2021 can be attributed to the Chinese government’s maintenance of a tighter monetary and fiscal stance that has helped CGBs to retain an attractive yield level relative to other global government bonds. Since the pandemic began in the first half of 2020, the People’s Bank of China (PBoC) has cut its seven-day reverse repo rate by only 30bps to 2.2%. Unlike many of its global peers, the PBoC has refrained from implementing quantitative easing and has, therefore, preserved the capacity, or policy room, to ease monetary policy at a later stage. Accordingly, CGBs stand out with their yield curve offering a positive yield spread of between 150bps to 200bps above G7 sovereign bonds (policy rates for G7 countries are negative or at zero bound, with deeply negative real bond yields).

China government bonds stand out with positive yield spread

Source: Bloomberg, data as of November 30, 2021. It is not possible to invest directly in an index. Past performance does not guarantee future results. 

In terms of fiscal policy, China is the only major economy in the G20¹ to meaningfully tighten in 2021. Over the year, China’s fiscal impulse turned to -2.5% of GDP. The net issuance of government bonds (CGBs, local government financing, policy bank) declined by CNY2.8 trillion over the first three quarters and is expected to be around CNY2.4 trillion less than 2020 overall.² Moderate fiscal tightening has capped domestic demand and prices, while lower bond supplies have helped flatten the long end of the yield curve.

On the currency front, the CNY has appreciated 2.6% against the USD and 8.3% against the China Foreign Exchange Trade System currency basket, which measures CNY value against a trade-weighted basket of foreign currencies. The strength of the CNY has been underpinned by China’s record trade surplus of over US$650 billion as China’s economy benefited from its resilient industrial supply chains, which have helped to mitigate stagflation headwinds.

Overall, we think both China bonds and the CNY remain attractive given the above factors, with ample risk premium attached to China’s local bonds and the currency. 

2022 macro themes: policy easing, impact of COVID-19 developments, and U.S. rate normalization

1 Weakening of Chinese domestic demand: a call to reengage in policy easing

Chinese policymakers finalized economic planning for 2022 at the annual Central Economic Work Conference on December 10, where GDP growth and inflation targets, monetary policy, and fiscal budget objectives were agreed on. We believe that sustaining a benign macro environment with stable growth and financial stability will be paramount ahead of the 20^th Party Congress, which is due to be held in the second half of 2022. The Party Congress is held every five years and is responsible for formally approving the membership of the Central Committee, which comprises the top leaders of the Communist Party of China.

Given the weaker economic data in the second half of 2021, we believe there’s a strong case for some moderate loosening of China’s monetary and fiscal stance, while additional credit and regulatory easing can be expected to provide relief to cushion the impact of the downturn in the property sector.

On December 6, the PBoC made a broad-based 50bps cut in the reserve requirement ratio (RRR) as had been widely expected by the market after the recent speech by Premier Li, when he indicated that the RRR would be cut to support the real economy amid increasing signs of downside risk. According to the central bank, this will unlock CNY1.2 trillion of long-term funding. We see the cut as a clear sign that the central bank has turned to policy easing to address negative developments in the economy, while further monetary easing can still be expected in early 2022.

2 COVID-19 developments: the Omicron variant and evolution of pandemic stagflation supply shocks

While we’re close to two years into the pandemic, there’s still no sign of a clear end in sight. Recently, risk markets have been roiled by the emergence of the Omicron variant and the uncertainty surrounding its impact on global growth. Economic data for the Chinese economy remains lackluster, and a deepening pandemic could result in further stagflationary supply shocks that would have important consequences on investors’ risk appetites and could encourage exposure to Chinese bonds in the short term. 

3 Interest-rate normalization: an exit of pandemic stimulus, Fed tapering, and the path to higher rates

The U.S. Federal Reserve (Fed) has proactively signaled its intention to increase the speed at which it can exit its pandemic stimulus while the market is also currently pricing in two 25bps rate hikes in the second half of 2022. Clearly, this will be an important theme for all asset classes and will directly affect the attractiveness of Chinese bond yields versus U.S. bond yields, as well as determine the relative value of the CNY against the USD. 

Our outlook for 2022: duration, currency, and credit 

To summarize, our base-case 2022 outlook for China bonds is as follows:

• We think China onshore bonds are projected to provide low- to mid-single-digit returns for investors, with the PBoC expected to take moderate easing measures, such as cutting repo rates by 10bps to 20bps. At the same time, the government’s fiscal stance will likely turn moderately expansionary.
• Due to the increasing divergence in global macro policy cycles, we expect China onshore bonds to maintain their low correlation to other fixed-income markets and continue to provide potential diversification benefits to global fixed-income investors.
• CNY strength could continue into early 2022 due to China’s elevated trade surplus as foreign investor flows into onshore bonds remain strong. The strength of the CNY should also help create a window for the PBoC to ease monetary policy even as the Fed embarks on a gradual interest-rate normalization path.
• Given the importance of the property sector as a key driver to China’s GDP growth, we believe the government will be cautious since it would want to avoid triggering a hard landing while reforming the sector. We think the government has enough tools to stimulate this sector and will ensure that the non-real-estate segment remains intact through tools such as tax cuts for small and medium-sized enterprises, the PBoC’s lending facilities, and special bond issuances by local governments. With respect to onshore credit, we’ve seen very little contagion to non-property sectors following the volatility in the property sector, and investor support for high-quality state-owned enterprises remains intact. 

From a positioning perspective, we believe investors can benefit from the following:

• There’s value in the intermediate and long end of the yield curve to add duration both on an outright basis, and relative to U.S. rates.
• We expect the CNY to remain relatively stable against the USD in the near term, as the currency should be anchored by a strong balance of payment flows. In regard to portfolios where CNY exposure is actively managed, this will be calibrated depending on developments related to COVID-19 and to the extent of the policy divergence between PBoC and Fed.
• In terms of credit, we see attractive valuations for high-quality names after the recent sell-off in September and October 2021 due to volatility in China’s property sector. 

To conclude, China bonds are expected to remain attractive in 2022, buoyed by potential moderate policy easing, China’s divergent macro-policy cycle versus other major economies, as well as sustainable strength in the CNY, which has been supported by China’s elevated trade surplus and persistent investor inflows.    

1 Manulife Investment Management, as of December 2021. 2 WIND, Manulife Investment Management, as of December 2021.