Reflections on COVID-19’s Impact on China’s Financial Markets
Investors who were underweight or not invested in Chinese stocks relative to their benchmark have found themselves underperforming. The yuan’s volatility has been relatively stable versus the US dollar, reducing potential return headwinds for US dollar-based investors, compared with other major markets. China can offer diversification within global stock and bond portfolios given low correlations with other major global markets.
Much has been written about COVID-19’s economic consequences for China, but here we especially look at the pandemic’s effect on China’s financial markets. For instance, how have China’s stock and bond markets performed on a global basis? What were the challenges that investors have had to confront during this crisis? Were there any divergences in experience between China and the other major markets? How does China look on a relative basis? These are some of the questions that we would like to address in this piece.
China’s financial markets managed to hold up reasonably well compared with their global counterparts as of end-May. For instance, Chinese equities outperformed other regional equities in the first four months of the year. In May, increased tensions between the United States (US) and China led to a slight underperformance of China relative to the US. However, the Chinese equity market’s year-to-date returns have been much better compared with its European, Asia Pacific or emerging market (EM) peers. Additionally, Chinese equities’ volatility (rolling 60-day annualized volatility) remained lower at around 19% compared with around 33% for the US, 31% for Europe, 22% for EM and 24% for Asia Pacific as of end-May.
On the fixed-income side, Chinese bonds provided solid returns of 3.8% in US dollar terms in the first four months of the year (5.1% in local currency (LC) terms). In May, both a currency depreciation against the US dollar and a rise in bond yields weighed on Chinese bond performance. Year to date, Chinese bonds returned 1.0% in US dollar terms (3.6% in LC terms) versus 5.5% for US bonds, 0.4% for yen, 0.5% for pound and -0.7% for euro. Excluding the currency impact, both euro- and yen-based bonds provided no returns in LC terms while sterling bonds provided a strong 7.7%. This highlights the more significant impact currency returns have had on the pound, which depreciated strongly against the US dollar. The yen has been a safe haven relatively speaking, while the yuan, despite its EM status, was relatively stable against the US dollar. Although the euro performed well in May, its volatility remained high on a 60-day rolling basis compared with the yuan.
Reasons Behind the Positive Performance
What has led to this positive performance? We believe that this was most likely due to the market’s confidence in China’s ability to contain the virus outbreak and also provide both monetary and fiscal support to its economy, consumers and companies. We note that there has been an escalation in US/China tensions, which hit performance in May. While the People's Bank of China did not cut rates as aggressively as the US Federal Reserve, Chinese bond yields fell by 54 bp in the first five months of the year, supporting returns. The sterling’s LC return performance was mainly due to the longer duration of the index at 12.2 years (versus 6.0 years for US and 5.6 years for China) as yields fell similarly by 53 bp during the same period.
The divergence in performance between the Chinese and global markets reminds us of the potential diversification benefits Chinese assets can bring to a global portfolio. Over the past 10 years, the correlation between Chinese (both onshore and offshore) and global equities has been 0.7, while the correlation has been even lower at 0.5 for China A-shares (onshore equities). The diversification benefits have been stronger for Chinese bonds, with a 0.3 correlation between onshore Chinese and global bonds. Given China’s domestically driven economy and the relatively early stages of its global market integration, we expect Chinese assets to continue to provide diversification benefits for the foreseeable future.
How Do Valuations Compare Today?
Since earnings are a moving target these days, assessing equity valuations has proved to be challenging. However, if we look at the 12M forward P/E ratios across markets and their ranges, we find that Chinese stocks are trading slightly above their 10-year median while most other developed markets show stocks trading at the top end of the range (the exception being Asia Pacific). This provides China with a little more wiggle room valuation-wise as earnings estimates get adjusted when analysts gain more insight into the medium- and long-term impact on companies from the pandemic-induced economic dislocations.
Economic growth appears to be recovering quite well, including consumption, and policy makers are continuing to provide support as necessary, which should give a boost to growth in the second half of the year. A second wave of the pandemic is a risk, but aggressive testing and localized lockdowns should help limit the spread. However, rising US/China tensions are likely to increase market volatility as there would be assessments regarding their potential negative effects on specific sectors and companies.
Chinese bonds continue to offer an attractive yield pick-up versus developed market bonds. At the end of May, China’s bond index was yielding 2.56%, a 121 bp pick-up over the US and significantly more than that versus other major developed bond indices. As it will likely take some more time before consumer and business confidence is mended, we expect further monetary easing in China, which should increase credit support in the country. This should provide further support for Chinese bonds in the coming months.
Market Volatility Throws Up Challenges, Particularly in Bond Markets
While China’s equity market volatility picked up in line with the risk-off environment, there was no real problem with general market liquidity. Investors, however, continued to face the usual challenges including a lack of liquidity at market closing, less liquidity for small cap stocks, rigid deadlines for settlement and operational challenges in booking orders, which are nothing new but require trading vigilance.
On the fixed income side, the unexpected elongation of the Chinese New Year holiday (due to the lockdowns) created a problem for settlement as the market did not re-open as expected. This forced traders to roll their trades over to the next open at a short notice. Settlement hours were extended after the holidays to help accommodate investors. Subsequently, the regulator introduced a settlement mechanism to negotiate failed trades, which was not available earlier. This shows that China is open to addressing the challenges faced by overseas investors as it drives toward the internationalization of its markets.
Interestingly, while global bond markets came under significant liquidity pressure (eased through central bank actions), China’s onshore bond market remained quite liquid through the period with only a modest widening in bid/ask spreads for on-the-run bonds although trade sizes were smaller. However, off-the-run bond liquidity was extremely thin or non-existent during the period. China’s off-the-run bonds have remained very illiquid during the best of times given the buy-and-hold nature of the market. Our traders scour daily axes from multiple counterparties looking for opportunities to buy off-the-run bonds on behalf of our clients. This is very important ahead of inclusion events.
One anomaly noted by our traders during the market sell-off was the divergence in pricing for the same bond on the China Bond Connect system compared with levels quoted on the China Interbank Bond Market (CIBM Direct). As Bond Connect is an electronic system, it offers ease of trading, but when market volatility and uncertainty rise, traders tend to be slow in updating pricing, resulting in diverging prices with CIBM Direct, which is traded directly with the traders. As SSGA was one of the first market participants to begin trading on China’s onshore bond market back in 2005, we made a conscious decision to trade most clients through CIBM, but we do have access to both the trading systems, allowing us to pick-up on various pricing anomalies. This highlights the importance of having an experienced manager while investing in China’s financial markets.
Key Takeaways From the Recent Experience
Investors who were underweight or not invested in Chinese stocks relative to their benchmark have found themselves underperforming as the China’s financial markets held up relatively well on a global basis. While the Chinese bond performance lagged in May, there was a strong outperformance during the worst of the market downswing in early 2020.
The yuan’s volatility has been relatively stable versus the US dollar, reducing potential return headwinds for US dollar-based investors, compared with other major markets.
China can offer diversification within global stock and bond portfolios given low correlations with other major global markets.
Chinese bonds provide a yield pick-up to global bonds, while Chinese stocks are trading just above the median P/E range compared with other developed markets that are trading at the high end of the range. This suggests China still offers some relative value.
There are unique challenges to investing in China’s financial markets. It is, therefore, important to have an experienced manager to help investors navigate operational issues and market anomalies that keep arising in this relatively less-mature market.
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