We are now in the second half of the year, and we remain concerned about the disconnect between the economy and markets and how quickly the pendulum has shifted to risk on.
Our key concern is there are too many assumptions that are increasingly being priced in as certainties, whereas the reality is not necessarily proving to be as sanguine.
Against this backdrop, we remain biased to Asia, and think China is offering up some of the best opportunities across the capital structure at present.
1) Government bonds
China government bonds have been a key asset for us this year. More recent performance has been challenging as yields have risen, but we see this as an opportunity to add at attractive levels to a key defensive holding offering a meaningful yield pickup over other government bonds.
Driving the rise in yields have been two phases of catalysts. In the first phase over May and June, the People’s Bank of China acted swiftly against levered carry trades given the rising volumes of structured deposits looking to take advantage of cheap funding costs, unlike in Europe where this activity is encouraged, and banks use cheap targeted longer-term refinancing operations money to buy peripheral Europe sovereign debt.
The second phase of rising yields covering July has been driven by meaningful rallies in China onshore and offshore equities; we would characterise this as a healthy development as we are seeing equity/bond correlation working in line with expectations.
This is unlike developed markets, where yields and interest rate volatility are anchored through quantitative easing and/or yield curve control, which we think could be a risk further down the line.
Finally, technicals are also positive given CGBs are under-owned by foreign investors and index inclusion is a major tailwind; by year end CGBs will be 10 per cent of the most widely used local currency EMD index, the JP Morgan GBI-EM Index.
2) High yield markets
We have a positive view on global high yield, with a bias to the China-heavy Asia high yield market. This has been a key area of conviction for us since the latter half of 2018; it was the strongest performing high yield market in 2019 and continues to outperform in 2020.
We see attractive valuations relative to other high yield markets, while fundamentals are also supportive, especially in the Chinese property sector - by far the largest sector in this market.
While the PBoC is not buying corporate bonds like the US Federal Reserve, strong technical factors are still in place as Total Social Financing continues to surprise on the upside - a tailwind for the high yield market.
We have a close eye on the potential for default rates to rise across global high yield markets and this extends to Asia as well.
3) Chinese equities
Chinese equities are another key area of focus for us. Since early 2019, we have seen resilient earnings, return-on-equity, and attractive valuations, supported by the structural tailwinds of a growing consumer sector and opening up of capital markets.