Volatility has been a theme across asset markets since the end of the first quarter. The year started off on a positive note with interest rate cuts, government stimulus and positive reform momentum in China, India and Indonesia. All of this supported strong performance across the region.
- Depreciating currencies and falling commodity prices should have been positive for most of the region but global demand has been overwhelmingly weak. As a result, the exports remain in a lull.
- The continuous disappointment in macro-economic data across the region, escalating concerns about the slowdown in China and the burst of the Chinese stock market bubble have all culminated a big change in the landscape for Asian risk assets.
With the US Federal Reserve indicating a rate hike on the horizon, emerging market risk assets, more recently including Asia, have suffered.
On China, we believe that the underlying growth picture is weak but stable, and that the Chinese authorities stand willing to take further policy action if required, as evidenced by recent stimulus. However,
- Sentiment is worse than the fundamental picture.
- Chinese authorities are trying to manage the slowdown without fuelling further credit bubbles, a delicate balancing act.
- We don’t believe China will significantly depreciate their currency to boost the economy.
We don’t believe a significant drop in the stock market will impact households via the “wealth effect” in a negative way. Only about 5% of household wealth is held in equities.
- The decline in commodity prices has been more driven by over supply than falling demand.
- China should be the largest beneficiary of commodity price falls since they are a net importer of commodities. They make up anywhere between 30-70% of global demand for major commodities.
- Infrastructure projects continue but at a slower pace than in the past as there is a gradual but definite transition to a more consumer driven economy.
Credit markets impact
- The impact of China on global credit markets continues to grow as more investors are either directly exposed to Chinese corporate bonds (via onshore), USD bond issuance or indirectly through supply chain linkages in multiple industries.
- China dominates Asian USD credit markets with large issuance across a variety of sectors including property, oil & gas, technology, utilities, provincial governments and a range of State Owned Enterprises (SOE’s). Global investors continue to be significant buyers of Chinese corporate bond issuance exposing them to the ebbs and flows of recent volatility and risk sentiment towards China.
- Chinese corporate bond spreads have been severely impacted by the recent stock market volatility, concerns about the economic slowdown and the broader widening in global credit spreads. We believe there remains pockets of strong relative value in Chinese financials, oil & gas and property companies versus the rest of Asia and globally. However we are wary of further market and economic uncertainty pressuring spreads in the short term. Entry point and relative value globally is critical at this time with an imminent Federal Reserve rate hike.
- We don’t believe the recent currency devaluation will have a significant impact on the credit quality of most Chinese companies despite having varying degrees of unhedged borrowings in USD. However looking forward there is a likelihood that Chinese companies will look to issue more debt onshore and Chinese investors will look to the value in USD denominated bond markets.
- Globally, we have already seen multiple defaults and a large number of credit downgrades impacting the coal and iron ore space first, with weakness now moving towards the base and precious metals area. We remain cautious on metals and mining however this sector has been one of the largest underperformers in investment grade and high yield during 2015 allowing for value to be found within certain low cost producers or other niche areas.
- China is the #2 largest importer of oil. We will see more defaults when liquidity dries up for high yield energy credits and many investment grade credits will be downgraded to high yield.
- China auto sales have also disappointed the market with a 3% decline in June and a 9% decline in July. Consensus growth forecasts for the year were for a mid-high single digit number and it is now highly unlikely that consensus expectations will be met. We believe that consumers’ confidence in China was shaken by the strong recent declines in the stock market, but fundamental trends for Chinese consumers driven by low unemployment rates remain supportive for a steady growth in the medium term.
- In summary, China’s impact on credit quality and global markets has been felt for some time. Volatility has increased recently with heightened fears of a slowdown and an equity market correction but this volatility has created opportunity for a fundamentally driven manager to pick those spots where prices and credit quality are misaligned. Until we see a clear bottom in growth and stability in the equity market there may be some further near term spread volatility for corporate issuers with links to China but global relative value will ultimately drive our long term decisions and performance.