Investment Strategy Insights: The Evolving China Mosaic
The unusual and colorful nature of American politics has diverted attention from what is a more central issue to the global economy: China.
China has begun a gradual rationing of credit, away from real estate and old line manufacturing into infrastructure projects. Will this more productive use of a less gushing credit spring keep the Chinese economy — and, by extension, the rest of the world — from slowing?
For anyone interested in the direction of interest rates, securities markets, and the global economy, the answers to that question couldn’t be more important or more difficult to predict. Given the dubious value of China’s official statistics, some throw their hands up at the challenge of cracking the black box. We view the challenge of assessing the prospects for the world’s lynchpin economy as a job of assembling a mosaic.
China has recently engaged in “qualitative rationing.” Total credit will still grow, in our view, but more slowly and will be aimed more surgically into what the government believes are more productive uses while still keeping the economy moving forward. Party leaders were chastened by the experience of 2015, when a “quantitative rationing” and abrupt slowdown of Total Social Financing (a broad based measure of credit) caused a China and global slowdown. This time, they are being more cautious.
They are taking a new, harder look at wealth management funds created by banks as off-balance sheet vehicles, which appear to be lending for speculative purposes. Given China’s increasingly levered status, they prefer to see incremental credit directed to the ambitious rail, road, port, and pipeline projects known as the One Belt, One Road plan to connect China more efficiently with Central Asia and Europe. The government has said it plans to invest about $1 trillion in this massive effort, which is aimed at cementing China’s economic dominance. At issue is whether the shift implies a lull, with real estate and commodity-based activity slowing before infrastructure spending rises. In all likelihood, we think this will happen. Yet in contrast with 2015, when China was the only party investing and their slower credit expansion slowed the world, today more businesses around the world are investing, which would likely cushion a Chinese pullback.
Why China’s change? The government is responding not only to elevated leverage, but also to some of the same encouraging signs that we see. The consumer has grown rapidly as a share of their economy and now is in better shape to carry their economy along in a less credit-intensive manner. Nevertheless, cooling China’s over-heated real estate markets still contains risks. Withholding credit could send prices of houses down sharply, an asset that underpins their banks. So supply of new construction is being managed down in tandem. Older, shoddily-constructed housing is also being vacated to make room for recent new construction.
The picture emerging from the mosaic, therefore, is somewhat optimistic. But pointillism is not photography, so where China is concerned, caution — and continued data-gathering — is essential.
INVESTMENT VIEWS & CONVICTION SCORE (CS)
Investment team views on how portfolios should be positioned for the next six to nine months.
1 = Bullish 5 = Bearish
Change from prior month is indicated in parentheses.
Economy CS 2.50 (unchanged)
Markus Schomer, CFA, Chief Economist, Global Economic Strategy
Our moderately bullish score of 2.50 remains unchanged, but we upgraded our view on risks. As a result of business-friendly Macron’s win in France, Britain’s June election that probably will strengthen Prime Minister May’s mandate, and a likely victory for Angela Merkel in the fall, European political risk has receded. Meanwhile, emerging-market developments support our thesis of faster global growth. We see signs of accelerating and broadening trade, especially in Asia, and greater industrial production in Latin America as Brazil recovers from recession. Continuing oil production cuts in Russia and Saudi Arabia should help commodity exporters.
Rates CS 3.00 (unchanged)
Roberto Coronado, Senior Portfolio Manager, Developed Markets Investment Grade
Ten-year US Treasuries remain in their recent trading range but are retesting lows due to political uncertainty stemming from doubts over passage of health care and tax reform legislation. Meanwhile, most growth forecasts are being revised lower. To raise rates in June, the Fed must overlook disappointing economic data, which it didn’t do in 2015-16. The main risk for higher US rates comes from bunds, as the market starts to price in further tapering and the end of quantitative easing from the European Central Bank (ECB). We continue our neutral outlook on US Treasuries with a bias for the five- to seven-year part of the curve given attractive roll-down. In global bonds, we are more positive on US Treasuries than on Europe given betterthan- expected European economic data and disappointment over the Trump administration’s handling of promised fiscal reform. After the recent retracement, we see value in TIPS and continue to prefer the five- to 10-year part of the curve, as we expect inflation to settle around 2%.
Credit CS 3.25 (unchanged)
Steven Oh, CFA, Global Head of Credit and Fixed Income
Following the French elections, volatility declined and credit spreads tightened. While first quarter US economic data was weak, the 2017 outlook remains favorable and Europe is improving. Political risk moves to the US, where concern mounts that the Trump administration may not deliver on expected expansionary policies. Continuing last month’s views, we favor loans over high-yield bonds for portfolio risk reduction, and investment grade over high yield for spreads, while neutral on loans. This is in keeping with our defensive bias and caution on European credit due to the potential for a shift in European Union (EU) policy later this year. We also continue to favor emerging markets (EM) investment grade (IG) over EM high yield (HY) due to the current spread premium and the former’s generally positive fundamentals; currently, there is effectively no premium for EM HY.
Currency (USD Perspective) CS 2.50 (-0.50)
Anders Faergemann, Senior Sovereign Portfolio Manager, Emerging Markets Fixed Income
US dollar sentiment has turned firmly negative as hopes for strong US economic growth weaken. Expectations of dollar-strengthening tax reform have been priced out, and any tax cuts are being seen as likely providing only a temporary boost. While yield differentials remain supportive, monetary policy divergence raises concerns. Talk of ECB tapering appears premature, but factors including stronger eurozone growth, rising inflation, and less political uncertainty in the wake of Dutch and French elections may drive market fears of ECB action following German state elections in September. And although EM currencies benefit from a positive risk environment, a weaker US dollar, and inflows, we see no evidence of marked improvements in fundamentals.
EM Fixed Income
USD EM (Sovereign and Corp.) CS 3.50 (unchanged)
Local Markets (Sovereign) CS 3.25 (unchanged)
Steve Cook, Senior Portfolio Manager, Co-Head of Emerging Markets Fixed Income
We continue our constructive view on EM debt despite valuations that are more difficult to justify. Already tight spreads in EM credit have tightened by an additional 15 to 25 basis points in the past month not as a result of fundamentals, which are benign, but due to continued robust inflows easily absorbing elevated levels of issuance. All eyes remain on US policy, where the current lack of any real progress combined with relatively range-bound US Treasuries may be supportive for EM assets in the near term. Overall, our conviction score remains unchanged.
Multi-Asset CS 2.40 (+0.20)
Sunny Ng, CFA, Portfolio Manager, Multi-Asset
Momentum for global economic growth is peaking courtesy of China, the Federal Reserve, and the ECB. All are poised to throttle back on stimulus, reflecting their higher confidence in intermediate-term fundamentals. Our view is that the acceleration of EM and European manufacturing exports will plateau. The growth has been the byproduct of China’s mini cycle, spurred by China’s early 2016 credit-induced stimulus and emboldened supply-side reform, which drove inventory re-stocking. That cycle is now peaking and should cool over the remainder of 2017. We nudged our CS from 2.20 to 2.40, a bit closer to neutral, while preparing for opportunities to add risk back later as the reflation regime reasserts itself. Overall, we favor a combination of select equities and floating rate instruments over credit and duration.
In equities, we find select exposures in the US most attractive, and we continue to favor financials, small caps, and value; Japan equity also remains attractive, in our view. In fixed income, we favor bank loans and asset-backed securities. While we expect defaults to remain contained, we are negative on high yield and investment-grade credit due to rising rates, deteriorating fundamentals, and tight spreads.
Global Equity CS 2.75 (unchanged)
Graeme Bencke, ASIP, Portfolio Manager and Head of Equity Strategy
A small deceleration in the US expansion and uncertainty surrounding prospects for the Trump/Republican agenda have led growth stocks to outperform cyclicals so far this year. Smaller companies in Europe also continue to outperform as lower correlations highlight ongoing market normalization. Solid first quarter results across most markets reflect synchronized global growth. Since we remain cautiously optimistic, any price correction likely would lead to an increase in our risk appetite (and lower CS score). Sentiment data, on which company management focuses as a lead indicator of demand, continues to be strong.
Global Emerging Markets Equity CS 2.50 (unchanged)
Andrew Jones, CFA, Portfolio Manager and Head of Equity Research, Global Equities
Emerging markets’ perceived catch-up potential versus developed markets (DM) and evidence of fundamental progress (as well as a lessened threat of US protectionist policies) have attracted flows to EM equities. Earnings revisions are quite positive and earnings quality is higher as well. Chinese economic data has softened month to date, and financial sector normalization is proceeding. Despite the pick-up in yields, it appears the People’s Bank of China’s plan is proceeding as desired. Success in social security reform likely would drive further market improvements in Brazil. We continue to be constructive given an improved EM-DM GDP growth gap, political reforms in several countries, better external balances, and growing cash flow in EM companies in aggregate. We see sector and individual security selection becoming increasingly important given pairwise correlations. We favor technology (some consumer discretionary-related), industrials, and financials. We dislike energy, consumer discretionary (partially offset by consumer IT), telecoms, and healthcare. We favor Brazil, India, and Greece while negative on South Africa, the United Arab Emirates, and Qatar.
Haibo Chen, Quantitative Analyst, Quantitative Research
The US Market Cycle Indicator continued to trend down due to the flattening curve. On corporate credit, both investment grade and high yield were rich compared to long-term averages. We remained negative on developed market credit, and among sectors, we favored banking, technology, brokerage, and capital goods over energy, electric, natural gas, and real estate investment trusts. On rates, yield levels were expected to increase globally; yield slopes were expected to flatten in the US, the EU, and the UK, and to steepen in Japan; and curvature was expected to increase in the EU but decrease in the US. Our rates model portfolio favored global duration, specifically those in Belgium, the Netherlands, France, Spain, and Denmark. On curve positioning, we like 20-year over other key rate durations.