investment opportunities in em bonds

China is not only the second biggest economy in the world, it’s also the second biggest bond market.¹ No wonder that when China sneezes, investors in emerging market (EM) bonds become nervous. But we believe there is no need for panic – for three key reasons.

For a start, China’s economic prospects are not as challenging as they first appear. 

Although the real estate sector remains weak, there are some bright spots elsewhere. Domestic tourism is now higher than pre-Covid, and outbound tourism is now back to over 50 per cent of 2019 levels (which also benefits the rest of EM Asia, such as Macau, Hong Kong and Thailand). The service sector more broadly is holding up well and public investment is strong.

Chinese authorities have also been proactive in shoring up growth. They have reduced interest rates and provided support to the real estate sector. Mortgage rates have been cut by 150 basis points from the peak and this tends to impact borrowers with a lag, so the benefits have largely yet to materialise. At the recent Politburo meeting, authorities pledged to step up counter-cyclical measures, which could include plans to help young jobseekers and the easing of purchase restrictions to support the real estate sector. The Politburo meeting omitted the phrase "housing is for living, not for speculation purposes" – an important signal.

Economists have recently downgraded Chinese growth projections for 2023, with consensus expectations converging towards the official forecast of 5 per cent. Although this is lower than initial expectations (of around 6 per cent after a very strong rebound in Q1), it is still a marked improvement compared with last year.

This, in turn, should help emerging markets more broadly to retain an attractive growth differential relative to their developed peers – to the benefit of EM sovereign and corporate bonds.

Fig. 1 - Growth boost

GDP growth, % q/q annualised, and EM local currency performance

We see the growth gap at around 4 ppts for this year and next. This is a sizeable buffer and thus, even if China’s growth was to fall short of current expectations, the growth gap between EM and DM would still be significant.

Our analysis shows that historically such a gap has been accompanied by the appreciation of EM currencies versus the US dollar and general outperformance of EM assets (see Fig. 1).

Secondly, while China is clearly a very important part of the EM universe, its dominance is not as strong as it once was. The fate of other emerging markets has de-coupled from that of China in recent years in terms of both macro and asset class performance.

Different approaches to Covid-19 lockdowns and policy responses have resulted in diverging paths for growth, rates, and inflation. China locked down more severely than many other countries. It is thus only now recovering economically and has not seen the sharp rise in inflation witnessed almost everywhere else in the world, to varying degrees.

While other EM central banks, especially in Latin America, have proactively raised interest rates over the past two years, the People’s Bank of China (PBOC) has stayed on an easing path to support growth. Now, other EM central banks are getting ready to ease monetary policy, which would potentially offer a huge boost for their local debt markets. Chinese assets won’t get such a marginal boost as the PBOC is already in easing mode, although its current monetary stance should be a slight positive rather than a hindrance to the general EM monetary easing theme.

The divergence also underscores decreased dependence of other EM economies on China through the commodity price link. Back in the 2000s, Chinese demand for commodities was a major boost for the developing world given the dominance of commodity exporters in the EM universe at the time. However, nowadays, EM is a much more diverse group and has a much more balanced ratio of commodity exporters and importers. Therefore, today’s lack of commodity demand from China is much less of a problem for the rest of EM than would have been the case 10 or 20 years ago.

Fig. 2 - Diverse returns

Performance of select GBI total return country indices

Not surprisingly, markets are also differentiating between Chinese assets and those in other EM (see Fig. 2).

The JP Morgan Local Sovereign index, GBI-EM, is up 10.5 per cent year-to-date in USD terms, whilst its China sub index is down 0.7 per cent over the same period. This mirrors currency performance – while, for instance, LatAm currencies have rallied this year, led by the Brazilian real, the Chinese renminbi has lost 3.3 per cent versus the US dollar.²