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China Led The Recovery Trade; Now Almost Everyone Is Cautious


(Bloomberg) — No matter the asset class, the outlook is turning bleak for China’s financial markets.

The nation’s stocks, bonds and currency are losing their shine after an impressive start to the year, overshadowed by a stronger dollar, higher U.S. Treasury yields and a domestic campaign to cut financial risk.

The nation’s benchmark stock index remains 13% below a 13-year high in early February, following a brutal selloff that wiped out more than $1.3 trillion in market value. The yuan just suffered its worst month in a year in March, erasing all its 2021 gains against the greenback. Chinese sovereign bonds, a sanctuary during the recent global rout, saw foreign investors lower their holdings last month for the first time in more than two years.

The sharp reversal of fortunes came as confidence grew in a strong U.S. economic recovery that is reclaiming the allure of dollar assets around the world. The latest underperformance of Chinese markets also resulted from Beijing’s decision to resume a battle on debt that was interrupted by the trade war with Washington and the pandemic.

Concerns about inflation and tighter monetary conditions mean appetite for Chinese shares will likely remain subdued, while the country’s government debt market faces the test of a supply glut later this year, investors and analysts say. The yuan could weaken further as the dollar extends its global resurgence.

“China’s bull run is being tested,” said Adrian Zuercher, head of global asset allocation of UBS Chief Investment Office. “Volatility will stay elevated in the near term.”

Subdued Trading

After delivering a world-beating rally earlier in the year, Chinese shares have reversed course since February, when it became increasingly clear that policymakers were shifting their priority to taming asset bubbles and reducing financial leverage.

The broader de-risking campaign also includes a crackdown on the country’s internet and fintech giants. In the latest of such moves, the authorities slapped a record $2.8 billion fine on Alibaba Group Holding Ltd. over the weekend after an anti-monopoly probe found it abused its market dominance.

While the penalty triggered a relief rally of as much as 9% in Alibaba’s shares in Hong Kong, those of its peers including Tencent, JD.com and Baidu fell by at least 2.7% amid concerns that they could be among the next targets of Beijing’s clampdown.

The onshore benchmark CSI 300 Index fell 1.4% at Monday’s midday break, bringing its year-to-date loss to 4.7% and down 14.5% from a peak in February.

The world’s second-largest stock market is $838 billion smaller than at its February peak and trading interest has been waning. Daily average turnover on China’s two stock exchanges was 670 billion yuan ($102 billion) so far this month, the lowest since May, according to data compiled by Bloomberg.

UBS’ Zuercher said he expects rising Treasury yields to be a major source of near-term volatility in China’s equity market, as it will continue to exert pressure on valuations of the country’s growth stocks and trigger rotation.

Echoing the view, Herald van Der Linde, HSBC Holdings Plc’s head of Asia Pacific equity strategy, said there remains downside risk to Asian equities in the near term and “China is no exception”.

Domestically, a central bank unwilling to keep funding conditions too loose, a contrast to its peers in other major economies, has also disappointed stock investors. Apart from its deleveraging campaign, signs of inflationary pressures, as shown in March’s consensus-beating 4.4% jump in China’s producer prices, could prompt Beijing to further dial back its pandemic-induced economic stimulus.

“We believe monetary policy might be tightened,” Hanfeng Wang, a strategist at China International Capital Corp., wrote in a note this week, adding that investors should pay attention to policy signals from the next meeting of the Politburo, the Communist Party’s top decision-making body.

Bonds Pressured

While Chinese government bonds outpaced their competitors in the first quarter as their haven status helped them stand out as a bulwark amid the global slump, they are facing a host of challenges in the coming months.

In addition to a longer-than-expected phase-in period for the inclusion in FTSE Russell’s World Government Bond Index, a surge in bond supply from local governments and a narrowing China-U.S. yield gap also threaten to reduce the appeal of Chinese debt.

Now at 3.21%, yields on China’s benchmark 10-year sovereign notes are expected to rise to 3.5% by the end of this quarter, according to Becky Liu, head of China macro strategy at Standard Chartered Plc.

As China’s yield premium over Treasuries thinned, global investors last month trimmed their holdings of Chinese government debt for the first time since February 2019, a trend that is expected to continue for some time. The yield gap fell to 144.8 basis points on March 31, the narrowest since Feb. 24, 2020 when it was 144.2 basis points.

Weaker Yuan

The dollar’s renewed strength, the tighter yield gap, as well as Beijing’s latest move to boost capital outflows also have prompted analysts, including ING’s, to lower their forecasts on the Chinese currency.

After rising nearly 7% against the dollar last year and reaping further gains earlier this year, the yuan suffered its worst selloff in a year last month, arresting a steady advance since May.

Read: Yuan Erases Year’s Gains Against Dollar as PBOC Steps Aside

Also weighing on the yuan is the slowing speed of capital inflows: Cross-border currency flows tracked by Goldman Sachs totaled $1.5 billion in the week ended on April 7, compared with about $3 billion in the previous week.

“It’s about how views on the U.S. dollar have changed rapidly,” said Zhou Hao, an economist from Commerzbank AG. “People believe the U.S. economy will recover strongly in the next two years and that’s what stocks and bonds have been pricing in.”

Zhou said he expects the yuan to weaken to 6.83 per dollar by the end of this year, from around 6.56 Friday.

(Updates with performance of broader stock market and tech shares in the ninth and 10th paragraphs)

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