China's Outlook and the Case for Quality Credit in Asia
A great sense of anticipation surrounds this week’s 19 th National Congress of the Communist Party of China. It could be a defining moment for the next decade, reshaping China’s political structure by further centralizing power under President Xi Jinping. As my colleague Isaac Meng wrote, while the Congress may usher in significant political change, we do not expect an upheaval to China’s economic policies . It is likely that financial risk control and macroeconomic stability will remain overarching objectives.
This may provide some comfort to investors. Indeed, Chinese policymakers have embarked on the path of a gradual, deliberate and controlled slowdown of the economy. The People’s Bank of China (PBOC) has been gradually tightening monetary conditions , and we anticipate further financial regulation, property curbs and interest rate rises. Despite this tightening, China has not been a major source of global volatility because supply-side reforms and the stable yuan have limited any negative spillover effects.
Capital flowing, yuan remaining stable
China’s macro environment has remained supportive of capital markets, with an improvement in growth momentum in the first half of the year (beating expectations at 6.9% year-on-year). In addition, capital outflows, which placed downward pressure on the yuan last year, have slowed and foreign exchange (FX) reserves have stabilized. This year's calm was initially driven by macroprudential measures and higher money market rates. Then in May, the PBOC made a countercyclical adjustment to the yuan-fixing mechanism in an attempt to ensure greater stability and encourage more pass-through of U.S. dollar weakness.
In any case, investors seem to be confident about China’s immediate future, and Asian financial markets have performed well. According to our estimates, in the first three quarters of 2017, emerging Asia has seen inflows of around U.S. $90 billion. Fixed income inflows have outweighed equity inflows by about 2 to 1. Reductions in the term premium on U.S. bonds have acted as a strong push factor, while growth in developed Asia has acted as a strong pull factor.
In addition, this year’s upturn in the export cycle has supported Asian currencies, including the yuan. Looking forward, nominal growth in Asia is likely to pick up, reflecting some recovery in real GDP and a gradual rise in inflation. However, the export growth cycle and the improvement in regional manufacturing indexes (PMIs) have peaked. In our view, the rate of inflows is likely to decline from earlier this year.
Against this backdrop, we remain overall neutral Asian FX, including the Chinese yuan, against the U.S. dollar, with overweights in India and Indonesia offset by underweights in Taiwan and the Philippines. Over our cyclical horizon spanning the next six to 12 months, we expect the PBOC to maintain capital controls while continuing to intervene tactically and signaling its policy intention via the daily yuan fixing. The yuan has already beaten many year-end forecasts, and so we believe much of the good news is already priced in.
Preference for investment grade credit
Asian credit has seen strong performance this year, mainly driven by local investors despite higher-than-expected issuance. Year-to-date, gross supply has been around U.S. $190 billion, already exceeding $169 billion in 2016, according to J.P. Morgan. China continues to dominate supply (at around two-thirds of total issuance on a net and gross basis) as issuers’ concerns over yuan weakness abate and rates remain low. High yield (HY) supply has been especially strong in China, where onshore liquidity remains tight. Despite heavy issuance, the local bid has supported tight spreads with almost 80% of Asian issuance placed locally. Although Asian credit spreads are close to their tightest levels since the global financial crisis, valuations are supported by fundamental improvements in both investment grade (IG) and high yield, compositional changes in the index and in-region demand.
We favor IG credit over HY in Asia given more attractive relative value opportunities and the fundamental improvement in IG. Local demand for IG credit is also more reliable, whereas the demand for HY is not as uniform and holds more idiosyncratic risk. This results in stronger technicals for IG relative to HY. Within IG in Asia, we favor the A-rated sector, which provides approximately 55 basis points (bps) in pickup over similarly rated U.S. IG. For BBB-rated credits, the spread is around 40 bps, while Asian HY trades almost flat to U.S. HY, further reducing its attractiveness.
Three key risks for China’s economic outlook
While our base case is that China’s slowdown will continue to be gradual and managed, there are potential risks to stability. These include geopolitical concerns surrounding North Korea, uncertainty relating to U.S. President Donald Trump’s trade policy intentions and the potential for policy errors as the Chinese government tackles financial excess. Any rise in U.S. protectionism would affect export-oriented segments of Asian credit, and a geopolitical crisis on the Korean Peninsula could lead to broader contagion in the region.
Read PIMCO’s latest Cyclical Outlook, “As Good as It Gets,” for further insights into the near-term macro outlook for China and the global economy.
Luke Spajic leads emerging markets portfolio management in Asia and manages Asian credit portfolios.
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