The Chinese yuan has weakened against the U.S. dollar and if there continues to be more trade conflicts between the U.S. and China, China?s economy will be affected more thus putting further downside pressure on the yuan as it will increase the price of commodities locally and will impact negatively on Chinese exporter profits. We expect the yuan could weaken to 6.85 yuan against the dollar. The yuan has declined more than 4% over the past month hitting one-year lows before settling at 6.7587. At the same time, the Shanghai Stock Exchange Index has dropped 14% over the past two months.
China is more dependent on the U.S. market for its exports than the other way round and a weaker yuan against the U.S. Dollar will assist in offsetting the U.S. tax on goods from China. On the other hand, other countries who trade with China may see this as a hostile act and retaliate. However, a stronger U.S dollar against all currencies would not only partially offset U.S. taxes on imported Chinese goods, but will also benefit other countries as their exports become cheaper thereby negating any reason to dislike China and a stronger U.S. dollar should not increase commodity prices in China.
The yuan?s decline has drawn comparisons with events in August 2015 when the People?s Bank of China (PBOC) unexpectedly allowed the currency to weaken against the U.S dollar triggering heavy capital outflows.
The difference between August 2015 and today is that the today?s depreciation is market-driven reflecting the risks of a further escalation in trade conflict whereas it was a crisis caused by the PBOC as it spent US$800 billion to slow the depreciation of the yuan. A repeat of 2015 is unlikely as China has more regulated capital controls.
President Trump has already threatened to place tariffs on $200 billion worth of Chinese goods and if this goes through, we should see further downward pressure on the yuan regardless of the efforts from the PBOC to stabilise it, a likely decline in China?s current-account surplus, lower economic growth and as a consequence forcing the government to inject additional liquidity into the economy though domestic policy easing achieved through a reduction in capital reserve requirements for Chinese banks to help promote lending and to slow the pace of regulatory tightening of the shadow-banking sector.
Diversify Across Asset Classes to Manage Risk
Long-term investors will look beyond trade protectionism, policies and tariffs to focus on China?s economic transition and recognise the importance of Chinese assets in their portfolios. Current uncertainties have created a good entry point for long-term investing. However, with volatility likely to remain high, we recommend investors to diversify into assets reflective of an expanding middle class and additional urbanisation. As the economy continues to undergo economic transition from a manufacturing-based economy to a serviced-based economy, we expect future economic growth to be lower but sustainable, driven by household consumption and the service sector. The domestic market has grown to US$20 trillion over the recent decades.
China has been home to the world?s second-largest equity market since the end of 2014 when it overtook Japan. Despite losing more than $1.65 trillion in market capitalisation since its peak in January and now at risk of being overtaken again by Japan, longer term China will continue to open up its capital markets as it desires further foreign capital to increase capital inflows, increased capital allocation efficiencies, and launch bond and stock programs.
Opportunities in Equity Market
Over the next years, we expect double-digit returns in equities based on higher economic growth compared to global GDP growth. For the moment, we would invest more in Chinese fixed-interest income assets versus onshore equities given continued external uncertainties relating to U.S. tariffs on Chinese goods and moderating domestic growth.
We prefer China offshore equities as they offer a greater return on equity (ROE) and some defence against yuan depreciation. When investing in onshore equities, we prefer small capitalisation stocks to larger capitalisation stocks as loosening of liquidity reserve requirements, changes in government policy and still robust corporate profit growth make current valuations attractive which have fallen to 2016 levels. As mentioned in our previous research note, we favour equities exposed to China?s growing middle class specifically in healthcare, consumer services and software sectors as the economy shifts towards consumption and services. In addition, healthcare equities are also likely to benefit from the country?s aging population. We would also invest in onshore electronic components and aerospace & defence equities that are likely to benefit from the nation?s industrial upgrade plan. Both the PBOC and the government are expected to provide more support to small and medium-sized enterprises by increasing lending facilities to offset downside risks from the U.S.-China trade conflict.
Opportunities in Bond Market
Within fixed income we prefer long-term government bonds as monetary policy will likely remain supportive to lessen economic headwinds and restrain corporate funding pressure amid deleveraging attempts.
We also prefer high-grade China Finance Bonds as opposed to high-yield China Finance Bonds as rising defaults, continued government efforts to squeeze shadow banking channels and general negative sentiment have put upward pressure on high-yield bond spreads.
We expect Chinese Treasury bond rates to come down as a result of deleveraging efforts and gradual growth slowdown. Current one- and ten-year government bond yields are 3% and 3.5% respectively. We expect total returns of 3% p.a. for shorter-dated government bonds and 4% p.a. for longer-dated bonds.
It is understandable why there continues to be increasing investment interest in Chinese assets as the market is very big and economic growth outpaces the U.S. China?s domestic growth will be increasingly driven by household consumption and the service sector as the economy rebalances from a debt-driven, manufacturing based economy. Based on our assessment, we expect returns in China to be above developed markets in the coming years. Despite the opportunities for investment in China, risks will be higher compared to more traditional markets in the years ahead? ?with the equity market particularly susceptible to external risks as seen by the recent U.S-China trade conflict. Nevertheless, with a well-diversified and balanced investment portfolio and taking a long-term view for investing onshore in China, investors can expect positive market returns.
HXL China Forecasts
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1-year Chinese Government Bond Yields?? 3.0% (year-end 2018)
10-year Chinese Government Bond Yields 3.4% (year-end 2018)
Chart 1: Three-month USD-CNY
Chart 2: One-year USD-CNY