What the Escalating Trade War Means for Asian Bonds

Author:
Arthur Lau, CFA
Co-Head of EM Fixed Income, Head of Asia ex Japan Fixed Income
Hong Kong

21 May 2019

Recent political rhetoric has increased the tail risk of not reaching a trade agreement, or of China needing to make additional, and broader concessions than what the market initially expected. This has implications across global asset classes, both fixed income and equity alike.

For the Asian bond market, the threat is less immediate because companies who issue bonds in Asia are more domestically focused. Yet, escalating trade tensions between the US and China do have implications for China’s growth in the future, and that could have an impact on bonds issued throughout Asia.

Tariffs will subtract from China’s growth

We believe the latest tariff hike on US$200 billion worth of goods (from 10% to 25%) will subtract 25 basis points (bps) from China’s GDP growth in the next year. If an additional tariff of 25% is imposed on the remaining US$325 billion worth of goods, another 40 bps to 50 bps will be taken away. The indirect effects such as weakening business sentiment and relocation of exporters to other countries are harder to estimate precisely, and we believe Chinese authorities will monitor these closely and step up stimulus policies accordingly. Moreover, it is important to remember the effects from the tariff hike are not linear. While companies may absorb the cost of the existing tariffs through margin compression, some of them may not be able to absorb any additional tariffs. Hence, the negative implications will become more pronounced and therefore hard to predict.

China is likely to step up policy easing

The perceived economic recovery in China was on a shaky ground even before this latest round of tariffs. April’s macroeconomic data were much weaker than expected. With the trade war escalation, we expect China to step up easing measures on both monetary and fiscal fronts. These could include making cuts to the reserve requirement ratio (RRR), managing down market interest rates, introducing supportive measures for consumption, speeding up infrastructure spending, and unwinding restrictive property policies in select cities.

In terms of the currency, we have been holding the view that the US dollar to Chinese yuan exchange rate (USD/CNY) is directly linked to the trade talks. Under our base case scenario, which assumes no trade deal is reached in the next few months, Beijing is likely to allow the yuan to depreciate to mitigate the tariff impact. If an additional tariff is imposed on the remaining US$325 billion of goods, we expect the USD/CNY to pass 7.0.

To avoid capital flight and excessive volatility in the stock market, we think the authorities may create some confusing signals of two-way volatilities for the exchange rate while the currency is on a depreciating trend. (One can argue that this could lead to a strong Chinese bid for US dollar assets, but then this could be offset by potentially tighter capital control.) We think China does not need to hold the yuan steady, especially if the trade negotiations fail.

The impact on the Asian credit market

The direct impact on Asian bond issuers is very limited because they focus mainly on the domestic market and are not directly affected by the tariff. We estimate less than 2% of the bonds are from issuers with direct revenue to the US. These include mainly tech companies.

The Key Sectors of China’s US Dollar Bonds Are Domestically Focused

The Key Sectors of China’s US Dollar Bonds Are Domestically Focused

Source: J.P. Morgan, as of 29 March 2019. For illustrative purposes only. We are not soliciting or recommending any action based on this material.

We believe the fundamental impact on Asian credit will mainly come via the second order impact of slower economic growth. This has varying implications depending on the area of the market.

  • Investment-grade corporates have been maintaining strong credit profiles over the cycle and should be able to withstand a potential economic slowdown.
  • In high yield, we believe the Chinese government will support the property sector given its importance to the economy. We expect large developers will remain resilient and benefit from potential easing.
  • We have turned neutral on commodities given the increased uncertainties in the growth outlook.
  • A weakening yuan could weigh on currencies in the region. Weaker local currencies imply higher debt servicing cost for US dollar bonds. However, dollar bonds in general do not account for a big part of issuers’ balance sheet or are partially hedged.

Overall, we believe the Asian credit market has less to fear from the trade conflict than the equity and foreign exchange markets do. However, more broadly, we are fairly bearish on the trade issue and believe markets seem too complacent. If a trade agreement cannot be reached, there’s a danger the US-China conflict could escalate beyond trade to the technological and geopolitical fronts.

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