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Video / 03 October 2017 at 12:30 GMT

Quarterly Outlook: China sets the stage

#SaxoStrats
   • Forecasters look for higher core yields
   • 'EM bonds have seen a huge revival'
   • Chinese bonds 'not falling behind' equity developments

Simon Fasdal
 
By Simon Fasdal 

The end of the year’s third quarter is an opportune time to evaluate recent developments in fixed income markets and also to compare the way things panned out with what had been expected. 

It is fair to say that market developments have been positive in the last stage of the quarter. Riskier assets, equities and higher yielding bonds have seen another push upwards, despite recently increased geopolitical tensions. The resilience seen in the market is almost epic. 

We entered Q3 against a positive backdrop, Europe seemed in better shape, many of the political and geopolitical risk triggers played a less important role towards the end of Q3, and risk-on trades became more significant. 

Our fear of a lower credit impulse becoming a new trigger that could potentially create a slowdown in the global economy did not materialise, nor did fears of China being the most vulnerable to lower credit impulse, and hence, becoming the train dragging growth south.

In bond markets we have seen an extension of the very fertile environment seen in most of 2017. The continued low yields, combined with quite positive global macroeconomic conditions, low inflation and low volatility have created the foundation for significant returns in many sub-classes of the bond market. 

Emerging markets were the biggest surprise with record year-to-date returns, even on a consensus that they would be vulnerable in 2017 due to Trump policies and lower commodities.

The end of innocence

Entering Q4 we stand against a positive backdrop when looking at the overall global economic sentiment, where one thing to notice is the recent pickup in growth surprise indices. 

Where growth indicators overall in the first part of 2017 disappointed, the third quarter has been a positive surprise, hence the developments seen in riskier asset classes, stocks and higher yielding bonds. 

All in all, this is a positive background to enter Q4, but does this mean there’s nothing much to worry about? 

Well, we could see a continued moderate positive development for riskier assets, and that will be our base case scenario. There is still room to the upside, as the global economy moves deeper into positive territory.

But the positive developments have once again ignited fear that inflationary pressures may materialise. For now, only more stable commodities and Chinese inflation are pointing upwards, but that can change going forward, despite our faith in a world without bottlenecks, driven by scalability, digitalisation and globalisation. 

These positive developments have been noted and a recent spike in European and US core yields, and a less moderate stance from the Federal Reserve have led to renewed belief in higher yields going forward. It will all come down to whether we see a continued positive development globally, and whether bottlenecks emerge. 

In that case we can expect more action from the Fed and the European Central Bank. More importantly, more action than is priced in, in the present market environment.

The critical point here is that emerging market bonds have seen a huge revival and are now trading at  2014-contracted spread levels. This can be justified, and one could argue that the expected positive correlation to US Treasuries is weaker than expected, simply because EMs are now more stable and more mature economies. But it is important to notice former Fed chair Ben Bernanke’s tapering comment in 2013, and the ensuing impact on core yields and other bond classes, especially EM. 

Were we to see a sudden spike in US Treasury yields, I would have an unpleasant feeling standing on the EM “one-way trail” with a sudden shift south in sentiment. 

Entering Q4, we are still cautiously positive on riskier bond classes, but with an increasing risk of setbacks due to higher core yields. Continued performance in core bonds will depend on negative economic surprises and increased geopolitical tensions. We believe these triggers will be of less value in Q4, and that the risk for inflation focus will increase, hence we downscale exposure in core bonds, and maintain the focus on riskier asset and bond classes.

China: opportunity or burden?

And that leads me to China, which has been in the spotlight for many reasons. It is the growth driver of the world, the potential credit bubble to end all credit bubbles, but also maybe the world’s most controlled central bank action. 

Back in 2016, the fear of a Chinese blow-out was exaggerated, but the fear was one of the triggers for a rough start to 2016 globally. Looking in the rear-view mirror, developments have in fact been positive. 

The Chinese local bond market has, however, been little noticed outside China, even though it is a $9.4 trillion yuan-based market, deemed the third-largest bond market in the world. This market, and its evolution, is something that cannot be ignored by market participants going forward. 

Last quarter we expressed our concern with the credit impulse, especially for China, and that investors should follow developments here very closely, as this could have significant impact on other financial markets, both good and bad. 

Fortunately, China has continued to develop favourably, with positive spillover to other markets and assets, for instance commodities, which lately have seen a revival in prices, against an overall broad base. 

China manufacturingSource: Saxo Bank

Chinese inflation and its impact on global inflation are also positive signs that we should not neglect. As a matter of fact, for the time being, everything happening in China is having healthy stabilising impacts on the global economy. So global investors should take notice and cross their fingers for a continued growth ride in China. 

In fact, the prospects look good. My Saxo colleague Peter Garnry is positive about Chinese equities and as far as i am concerned, fixed income is not falling behind: with renewed technology and in a very structured manner, the China Bond Connect is an evolution for the Chinese financial market. 

It is more than a technological and digital invention, it is a way to open up the Chinese market and really make a leap into globalising the world’s third-largest bond market.

The wish for China and the People’s Bank of China to open up the market and engage globally is seen as very positive. We should not forget the hidden value that emerges when closed, low- transparency and low-liquidity financial markets open their doors and become accessible to all investors. 

Furthermore, Chinese assets might be the missing link in many global portfolios, which now can add assets from one of the world’s largest and fastest growing economies. 

We expect these developments to make positive impacts on the Chinese and Asian financial markets going forward and result in a positive spillover to other financial markets around the world.

— Edited by Michael McKenna

Simon Fasdal is head of fixed income trading at Saxo Bank

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