Thank you for listening to this podcast, that is part of a series dedicated to the Fox news outlook 2022 event. My name is Mariah home . Well fixed income investors, search for basis, points of yield in developed markets, Chinese policy and treasury bonds offer an average yield to maturity of 2.9%. That's an extreme premium compared to the Euro bonds aggregate index of 0.0 81%. And even us bonds aggregate of one point 74.
And what seems too good to be true, rarely is not the trouble surrounding real estate agent ever grown. They could take the economic stability and harm the reliability of the Chinese government. And while inflation is growing supply chain problems continue to be present. Could the premium be justified given the higher risk? I'll talk about that and more with my guests of today. Jason Simpson, fixed income analyst at state street. SPDR ETFs. Welcome Jason. It's wonderful to have you
Well, thank you very much. Yes. Um , wonderful to be on a podcast about such an interesting topic as China, it's in the news quite regularly and it's , uh , you know, the world's second biggest economy. So certainly something that I think should interest interest a lot of people.
Well, let's definitely get, get into everything in, in more detail. Let's start with this ever ground a situation. Do you think it could destabilize the Chinese economy?
Yeah, always, always get to start with the, the thorny issues first , uh, in terms of , uh, I guess the risks , uh, so posit some of the risks up front. So , um, I think it's fair to say that it could well weigh on growth. Um, but I don't believe that the Chinese authorities will, would let , uh, ever grow and get to the point where it becomes a destabilizing factor.
Um, I think what is happening in China at the moment is very much a situation where the government is trying to reclaim control over a lot of points of the economy, whether that's real estate or in the education sector. And I think they're pushing back. I think they're just saying, look, you've got a high leverage business. This isn't an issue for you that you have to sort out as a private business. Um, and , uh , not relying on the state to , to come riding into , uh, into rescue use.
So, you know, it's a classic case of, they don't want the gains to be privatized. And the loss is socialized has happened when we were in, you know, sort of , uh , a company becomes too big to fail. So , um , I think that's the route they're taking and they're controlling that process. So , um, you know , if, if it was to go wrong, I do think though that the Chinese authorities have the resources to, you know, to , to , to sort out the problems as , as they occur. Right,
Right now, recent economic numbers from the world bank IMF indicate that China's economic growth is slowing in pace. What is your outlook, Jason for the Chinese economy?
Yeah, I mean, obviously China's been one of the major growth stories of this century. Um, it's sort of almost , uh , gone up by pretty much gone up by a factor of five since the turn of the century, so is amazing growth. Um, but obviously sustaining that growth, it becomes more and more difficult as the economy gets larger and larger. Um, you know, in particular, obviously, you know , the early two thousands, it was sustained by by exports.
So that was the big the model then , um, as that has become more tricky to continue to grow the export sector, they've moved away from that , um , from manufacturing into more into the services economy. The problem there obviously is , is the aging population that means , um, that , uh, you know, consumption, isn't going to continue to rise , uh, in China, put on a per head basis. Um, uh, maybe as quickly as they'd like. So , um, overall the growth trend is going to moderate.
Um , I think near term, they've also got some, some tricky issues as we've already discussed in the real estate sector, but they've been hit by a lot of the same , uh , problems we have with higher prices. They've had energy shortages , uh, supply chain problems , um , and that's, you know, resulted in the manufacturing, PMI being below 50. Uh, they've obviously, you know, COVID is a constant issue out there where they have a habit of locking down the economy when there's an outbreak.
So, you know, our official forecast for growth is around about 5% this year. It's down from, you know , probably around 8% this year. Um, but I suspect , uh , it could be , uh, the risk. There is maybe a little bit on the downside to that 5%.
No, no. In the Eurozone and the United States , uh , inflation is growing above expectations. How does that affect the Chinese economy?
Um, yeah, I mean the subject to the same sorts of issues or rises in prices as the Western economies. So in particular things like energy and commodities , um, and supply chain disruptions of , uh , of hit hit them just as they've hit most of , uh, most of Europe in the U S so PPI there rose to 13 and a half percent recently. So, you know , costs, input costs for the firms are rising.
I think what might make things a little bit easier though, is the fact that, you know, European and us , uh , demand has held up pretty well. Um, you know, there's still this sort of reopening of the economies here, which, which really has allowed producers to pass on a lot of these costs. And that's why we're getting a lot of inflation here. Um , but the inflation doesn't seem to have been of the sort that's really pushed down on consumption just yet.
Uh, so that that's actually probably facilitated the Chinese manufacturers pushing , uh , price rises on to, you know, to us. So it's not maybe as been quite, quite such a bad impact there as , um , as we're feeling it over here.
Right. So , so the inflation in China has been rising since 2019. How does that affect a fixed income investors? Jason?
Um, I mean, CPI searched , uh , into early 2020 , um, but then, you know , fell quite dramatically actually around the , the COVID outbreak. It's been slightly slower to pick up , uh , than in most Western countries and zone you reach one and a half percent. So what's interesting is, well , I say producers can push on those price rises.
They're struggling to do that in China domestically, but they have done that sort of externally in terms of their exports, but from a perspective that inflation has remained a little bit more contained that than say Europe or the U S where it's really has surged. Um, I think that's great news for , for bond investors , um, because real returns are much higher.
Um, so for instance , uh, you know, Chinese , uh , 10 year yields , uh , sort of two 90 as you , you mentioned at the beginning of , of , of the session , um , and that's a hundred and sort of 40 basis points over their inflation rate. Conversely, if you're looking in , in the us , you get a yield of sort of 1 55 against CPI of , of 6.2%. So that's a negative real yield of 465 basis points.
So, you know, that positive, real yield that, that extra yield you're getting on top of inflation there is, is, is really, or should be viewed as appealing , uh, from an investment.
But let's dive maybe a bit deeper into that , uh , bone market , um , on your website, you say that Chinese bone market were not very accessible until 2019. What has changed there? Exactly. Yeah .
I think the story maybe starts a little bit before that. Um, so 2016 , uh, I guess is , uh , where the international access to the onshore Chinese bond market really started to open up. So prior to that, you could be involved. State street was involved prior to that 2016 point, but, you know, there was a quota system , uh, the required regulatory approval for, for investors. And there were limits on investment and holding periods and et cetera, et cetera.
So it was quite a restricted , um , in 2016, the government opened up that market for direct access. Uh, so that was a , that was just the first step , uh, 2017 China introduced the bond connect system, which sort of made it easier for financial firms , uh , to buy bonds through Hong Kong. So, you know, these were big steps in terms of opening up those Chinese opening up that market externally.
But I think the big development since 2019 has really been on our side , uh, in, in that indexes have started to include Chinese government bonds in them. So in April, 2019 , uh, Chinese exposure was included in the Bloomberg Barclays series of, of indices. Um, from early 2020, they were included in JP Morgan in those, the EMDR indices there. And then from October, this year, they're being included in the, in the footsie Russell, the world government bond index.
So it , it, you know, the opening from their side, it occurred. But I think the difference now is that we are, we are looking at integrating Chinese bonds into all these global portfolios, and that makes a big difference.
Um , and when we look a bit more of the specifics of , of the Chinese of bond market, what would you say is the relative size currently? Well , big, big to find things ,
Everything in China , um, you know , on short bonds , uh , that there's over 125 trillion remember , uh , that , uh, in, in, in dollar terms that's around about 20 trillion. So , uh, that makes it , um, the second largest market after the U S it makes up around about 7% of the Bloomberg global aggregate index. Uh, and he's going to make up 5.6% of the world government bond index, that footsie index I was talking to you about. So, you know , Rudy is too big for investors.
Yeah, indeed. And what is the sheriff of foreign investors in this bond market? Yeah ,
I mean , it's at the moment quite restricted. So if you look at the entire market , um, uh, then it's quite small three to 4% , um, but for straight government bond exposure. So just like the Chinese treasury market is closer to 10%, but that's still fairly low relative to most developed markets.
Uh, so, you know, our view is firmly that developed market investors are underweight Chinese exposure, and , and I thought very interesting on this point, I was in a wonderful conference in Amsterdam last week, run by yourselves . And , um, in one session we asked the attendees , um , who , who in the room who had exposure to Chinese government bonds in their portfolio.
And none of them had not , not as a direct exposure, maybe as part of sort of an em debt portfolio, but no bit nobody admitted to having Chinese bonds as a, as a sort of standalone or an addition to their own portfolios.
And that's something you will, you will hopefully,
That's what we are in for
Exactly. Um , which , uh , segments can, can you differentiate?
Yeah, I suppose it can be split down and we split it down into three different parts. Um, so government bonds , uh, which is principally just the treasury, although they're a little bit , uh , local government bonds, but the main part is treasuries. Uh , that makes up just under 40% of the amount outstanding. And then there's something called policy bank bonds, which around about 35%. Those are, you know, like development banks that are state sponsored.
So they've got a state backing and quite, you know, it is quite a deep and liquid market there as well, but there's a little bit smaller than just the straight treasuries. And then there's corporate bonds issued by Chinese corporates that , that make up around a quarter or sort of 25% of the market then .
Right. So when we look a bit more at the investment side and , and your strategy , um , what's the role of Chinese bonds in an investment portfolio?
Yeah, we've touched on it already, but I think the most obvious is a yield enhancer. A yield on the 10 year is sort of two 90. So that's well above one and a half percent. You're getting on us tenure . So, you know, for Euro investors in particular, that's an even greater improvement in yield. Um, you know, to get something similar, I guess you'd have to invest in Euro high yield. Uh, obviously there's no currency risk with that, but it does of course mean a big drop in credit quality.
So Chinese , uh , government is, are rated a sort of an, a one or a plus. Uh , whereas , um, you know , if you're looking at Euro high yield is probably more like us , a , B one or B plus. So , um, so, you know, there is more of a, a liquidity and a ratings boost from, from looking at investing in China, Chinese treasury , um, second point, I think, which may be not quite as well covered is, is as a diversifier.
So, you know , intuitively if you include different moving parts in your portfolio that sort of dampens down volatility , um, and you know, if you look at China, it's got a very different policy cycle. So, you know, the central bank there moves in different way and therefore their bull market moves in a different way to European bull markets, for instance.
So the moment, you know, the , the PBC has , um , been easing liquidity measures , uh, to support the real economy and could well cut rates , uh , in 2022, you know, while we're all sat here saying, you know, we'll , hold on the fed and the, you know, is going to potentially raise rates, bank of England, potentially raise rates , uh, as next move in China, it's the opposite.
So adding in some exposure to China in your fixed income portfolio can , um , both boost returns and reduce the volatility.
Right. And what would you say Jason is the correlation between China government bonds and other important bond markets?
Yeah, so, I mean, if you look at it on an, on a sort of dollar unhedged basis, so , um, you know , it would be very low around about 14% taking sort of roundabout 15 years of data. So 14% against , um, dollar bonds and around about 17% against Euro. But, you know, I think perhaps what's more remarkable to me, so that makes sense. But I think what's more interesting is, is the low correlations that it has to, to other M uh, local currency debt. So that's only 17% correlation.
So, you know, people think of China is this sort of M nation. Uh , and it is in obviously in a lot of respects, but the bone market does not behave like it. Um, and a key reason though, is because the , remember the currency is managed against the dollar.
So well from a lot of emerging market nations , uh, the currency becomes a sort of key pressure valve where , uh, when you get sort of times of stress, you get risk off, then that currency fools a lot, and it can be quite detrimental to your performance. So your returns for your portfolio, the, the Chinese currency is managed within a 2% band each day, so it can move. Absolutely. Um, but it's not got that volatility that you'd see in another em , bond markets .
So , uh, from that perspective, I think it , it does , uh , you know , add in that stability.
Right? You mentioned volatility and, and maybe you can tell us a bit more because , uh , indeed one would expect more volatility , uh, given the yields that Chinese bond offer. Is that true?
Um, well, no, not really partly because of what I've explained before about the currency, but also the size of the market is a very liquid deep market. Um, you know , I think what strikes me as being the most interesting observation here was if you looked at Chinese bonds in, in that, during that COVID , uh , crisis, they were behaving far more like us treasuries than any em bonds. So Ian bonds sold off because it was a big , big paring back by investors of risk.
Whereas, you know, treasury rallied because that was the safe Haven, but Chinese treasuries also rallied , um, you know, there is evidence that they are treated as a sort of safe Haven asset. And I think, you know, if you look at it on an unhedged basis over again, over the last 15 years, volatility has only been marginally higher than us treasuries , uh, but actually lower than Euro gov is, or UK gov is Australian debt.
Uh, so, but then you're getting these extra returns on top of even treasuries. So , uh , that's what principally, while we were very keen on this exposure.
Right. And , and why did you choose to only include government bonds in , in your China bond ETF?
That's a good question , um, for their liquidity , uh , uh , and also as I've mentioned for the safe Haven status to be enhanced liquidity, we've also got in the index, we follow a minimum amount, outstanding of a hundred billion. Remember sounds like an awful lot, but that's around about 15 and a half billion dollars. Uh, so this really focuses the index on the sort of 50 or so of the most liquid Chinese bonds.
Um, and, you know, I think liquidity in an environment where investors aren't necessarily sure, or that confident that, that , uh, what , uh, what they're getting in terms of a lot , as we said, a lot of people aren't familiar with Chinese bonds. We wanted to focus on that sort of really liquid exposure, you know, and I think a few years ago, that was a case for maybe looking at that policy, those policy bank bonds, because they provided a meaningful uplift in yields.
Um, however, there has been a big convergence there and the, you know, the additional yield that you get by the inclusion of those policy bank bonds is sort of only sort of five to 10 basis points now. So, you know, you then take on obviously the risk that those spreads might move back out. So we've decided to focus just the pure treasury.
Um, we're , we're reaching the end of this interview. Um, but maybe as a final question, why should investors use passive instruments to, to access that Chinese bond market? Jason?
Okay. Yeah. And that's , um , this is another good question. I mean, for , you know , as I said, for those who are not that familiar with Chinese debt or not that comfortable , uh, with , uh, trying to build a portfolio, you know, obviously building that portfolio can be expensive and time consuming. So, you know, building that up from scratch, if you don't have a prior exposure.
So I think, you know, ETFs as with a lot of exposures are relatively cheap way to gain exposure to a portfolio of Chinese bonds. So , um , think that's a , you know, that that's a major draw, but , um, you could also obviously go into an active fund , but from my perspective, in a, given this as a government exposure, it's unclear how much value you can really add through active management.
I mean, it's not a surprise that we've seen a lot of government exposure shifting to the passive side , uh , over the last sort of five years. And that is because it with spreads very tight with , um, you know , uh, liquidity , uh, very high in a lot of these markets, it's become a lot more difficult for, for act. You've got to take quite a lot more risk to get that , uh , additional , uh, return from an active portfolio.
So, you know, so we think that a passive is certainly the way to go for government bond exposures and, and a few other things. Um, but that's why, you know, we've launched this exposure and I'm hoping that people see the value in it.
Thank you so much, Jason, for being here with me and for telling us more about Chinese bonds.
Thank you very much.
I would like to thank my guest Jason Simpson for his time and his insights. This podcast is offered to you by state street SPDR ETFs. It was recorded as part of his series dedicated to outlook event 2022 for more both costs, please visit fonts news, Dutta now forward slash podcasts. And if you'd like to know more about state Street's outlook for 2022 and beyond, please visit state street.com.