A sheep in goat’s cloth­ing

Financial Mirror (Cyprus) - - FRONT PAGE - Mar­cuard’s Mar­ket up­date by GaveKal Drago­nomics

In the West, ‘sorting the sheep from the goats’ is a com­mon metaphor for sep­a­rat­ing the good from the bad. The Chi­nese lan­guage, how­ever, does not dif­fer­en­ti­ate be­tween the two species. So as the year of the sheep (or goat) ap­proaches, it is per­haps un­der­stand­able if some in­vestors are ask­ing which sort of beast China’s off­shore dim sum bond mar­ket rep­re­sents. With China’s growth slow­ing, with the ren­minbi down -2.3% against the US dollar in the off­shore mar­ket over the last three months and with re­newed doubts about the qual­ity of is­suers fol­low­ing prob­lems at Hong Kong-listed prop­erty de­vel­oper Kaisa, some are ask­ing whether the dim sum sheep is re­ally a goat.

As in any bond mar­ket, there are three dif­fer­ent el­e­ments to as­sess: du­ra­tion, qual­ity and cur­rency. Let us re­view each in turn.

Du­ra­tion. For the six months to the end of Jan­uary, be­ing very long du­ra­tion was the right bet in al­most ev­ery bond mar­ket in the world. To our mind, long-dated bond yields col­lapsed for two rea­sons:

1) The burst­ing of the oil bub­ble. The burst­ing of any bub­ble is de­fla­tion­ary as it im­plies the write-down of a large amount of cap­i­tal. But the burst­ing of the oil bub­ble is dou­bly de­fla­tion­ary: not only will we see large cap­i­tal write-offs, but the lower oil price has had an im­me­di­ate im­pact on con­sumer in­fla­tion mea­sures all over the world.

2) The Euro­pean Cen­tral Bank’s quan­ti­ta­tive eas­ing. His­tor­i­cally, global bond mar­kets have tended to fol­low the lead set by US trea­suries. But in the last six months we saw this his­tor­i­cal re­la­tion­ship up­ended as the mar­ket ‘front ran’ the ECB’s QE pro­gram. As bond yields across Europe cratered, along with the euro, in­vestors clearly felt that tak­ing on more du­ra­tion risk in the US, UK, Asia and else­where made ex­cel­lent sense. As we look at it, this ‘du­ra­tion party’ has now come to an end. Cur­ren­cies are broadly sta­bil­is­ing and bond yields are no longer fall­ing, so it looks as if the time to put on du­ra­tion risk is be­hind us. Of course, Chi­nese fixed in­come in­vestors never got to party as hard as ev­ery­one else in re­cent months, for the sim­ple rea­son that the amount of long-dated pa­per in the dim sum mar­ket is very limited. But what goes around comes around, and the ‘re­tour du ba­ton’ could well work in favour of shorter-dated dim sum bonds over the com­ing months.

Qual­ity. There was a no­table sell off in low-rated in­stru­ments in late 2014 and early 2015, mostly in re­sponse to the Kaisa ‘bust’ and the per­cep­tion that a lot of prop­erty pa­per could be due for re­struc­tur­ing. Never say never (as the lat­est head­lines about the mag­ni­tude of Kaisa’s debt pile re­mind us). But it still seems more likely that white knights will be pushed for­ward to bail out cred­i­tors at the last minute-the last thing Bei­jing wants is a se­ries of scan­dals to un­der­mine the cred­i­bil­ity of its brand new bond mar­ket. It is even pos­si­ble that the au­thor­i­ties could ease pol­icy to help the guys who are in trou­ble-Bei­jing fol­lowed Novem­ber’s rate cut with a re­duc­tion in bank re­serve ra­tios this month. Hav­ing said that, th­ese cuts re­flect the re­al­ity that Chi­nese growth is slow­ing. The key ques­tion is whether it is slow­ing enough to trig­ger bankrupt­cies in the dim sum mar­ket. We do not think so. In­stead we would ar­gue that, in the post Kaisa sell-off, in­vestors have been too ready ‘to throw the baby out with the bath wa­ter’. For in­vestors with knowl­edge of the risks of in­di­vid­ual cred­its, the prospects of pick­ing up some de­cent yields look pretty good. (Granted, you could say the same about US high yield. In this sense China is hardly unique.)

Cur­rency. This is where things get in­ter­est­ing. How much, if at all, will the ren­minbi go down against the US dollar over the com­ing year? In the last three months the Chi­nese cur­rency has lost -2.3%, and stands close to a 2.5-year low. The most im­por­tant thing to note is that un­like the fall that took place this time last year, it can’t be said that this fall re­flects a de­sire by the Peo­ple’s Bank of China to shake down over­lever­aged, long ren­minbi spec­u­la­tors.

This time around the fall is mar­ket-driven. That trou­bles the bears. How­ever, the ul­ti­mate ar­biter of the ren­minbi’s ex­change rate is not the mar­ket, but the PBOC. And when it comes to ex­change rate pol­icy, the cen­tral bank has an over-rid­ing in­ter­est in keep­ing the ren­minbi sta­ble against the US dollar, both to fur­ther its long term strate­gic aims and to de­ter mass cap­i­tal flight lest it trig­ger do­mes­tic fi­nan­cial in­sta­bil­ity.

In con­clu­sion, viewed though the triple lens of du­ra­tion, qual­ity and cur­rency, the cur­rent op­por­tu­nity set in both high yield short-dated pa­per and in long-dated ren­minbi gov­ern­ment bonds re­mains at­trac­tive - es­pe­cially on a struc­tural ba­sis for in­vestors based in the euro, Bri­tish pound or yen. In fact, fol­low­ing the re­cent ‘counter-trend’ dip in the ren­minbi against th­ese three cur­ren­cies, in­vestors should ask them­selves whether over the next year the dim sum mar­ket will ac­tu­ally prove to be a sheep in goat’s cloth­ing.

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