The most important positive driver for total returns in bonds is that the market has stepped up expectations for further policy easing in China. Growth has clearly been affected by pandemic difficulties and recent Purchasing Managers’ Index (PMI) surveys point to contraction in activity expectations across the economy. As a result, an accommodative policy stance is expected throughout the rest of the year and most likely through to Q1 next year before the next budgetary cycle. The government and central bank will be keen to maintain loose financial conditions and lower bond yields will be a key component of these efforts. The yield on the 10-year Chinese government bond fell below 3% in early Q3 and we doubt there will be any recovery to above this level in the near future as domestic demand remains strong.
One other important domestic factor will be the resolution of current issues surrounding particular companies within the real estate sector and ensuring that no systemic risk arises. Regulators have been aware of the problems for some time now and the recently released 2021 Financial Stability Report does not expect material threats to financial stability, even under extreme-stress, tail-risk scenarios.
Global duration developments over the coming months could affect China’s bond market in different ways but, overall, we believe the environment is benign. The Federal Reserve has affirmed a very gradual tapering path and the process is now fully in the price of bonds. Long-dated bond yields have fallen due to expectations of activity restraint. The case for rotation out of emerging market debt markets and back into the U.S. is not as strong as compared to early Q2 or even in June when the Federal Open Market Committee (FOMC) decided to bring normalization expectations back on the table. Outright U.S. interest rate hikes will have a bigger effect, but these are likely to be roughly a year away.
The biggest short-term concern is more around stagflation, which is affecting economies globally. China is struggling in particular with a wide Producer Price Index (PPI) to Consumer Price Index (CPI) gap. The knock-on impact on corporate profitability could affect sentiment on the margins but, again, this will be offset by policy support from the People’s Bank of China (PBoC).
Finally, on a technical level, we continue to see favourable developments through year-end as index inclusion flow proceeds apace. Barring highly unlikely last-minute changes, the inclusion process of Chinese sovereign bonds into the FTSE Russell World Government Bond Index will begin in October, but the pace will be over three years rather than 12 months. This will affect the overall flow picture and we do not expect a purchase pace matching anything witnessed in 2020, but the allocation process will be felt given the pace will amount to between US$10 billion and US$12.5 billion per quarter on a passive basis.
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