Opportunities in China

It has been an eventful year for China’s economy and its financial markets, highlighted by slowing GDP growth, volatile equity markets, currency devaluation, and various forms of government stimuli. While these events may have caused some investors to underweight or avoid China altogether, we believe that these are not signals of the beginning of a hard landing, but rather of a country in transition. China’s formula of abundant labor and high investment to generate growth is coming under pressure as the country’s workforce shrinks and fixed asset investment slows1. But while China as a whole may not churn out 7% growth anymore, we believe opportunity lies in more targeted investments, including its onshore bond market and sectors that will benefit from China’s ‘new economy’.2,3

Chinese Onshore Bonds

Chinese onshore bonds, as represented by the Global X GF China Bond ETF (CHNB), have been one of the best performing fixed income markets in 2015 (see chart below).

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For US investors, China’s fixed income returns are based on the price returns of the bonds, the income they generate, and the currency returns between the Chinese onshore yuan (CNY) and USD. While China’s currency has suffered in 2015 since the People’s Bank of China (PBoC) moved to devalue the yuan, its price return has benefitted from six interest rate cuts in the last year and its relatively higher yield compared to US, European and Japanese bonds.4,5,6

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Looking ahead, China’s onshore bond market could benefit from two potential sources: its price return from continued interest rate cuts if the PBoC looks to stimulate economic growth and currency appreciation from the IMF’s inclusion of China’s yuan in its Special Drawing Rights (SDR) currency basket. The IMF recently accounted the yuan will be added to the SDR basket, allowing IMF members to freely convert currency into the yuan to meet balance of payment needs7. Standard Chartered Plc and AXA Investment Managers have predicted that $1 trillion of global reserves could convert to Chinese assets if the IMF adds the yuan to the SDR basket, resulting in an enormous amount of buying pressure that could drive currency and asset prices higher8.

China’s ‘New Economy’ Sectors

There has been over a 21 percentage point difference in 2015 between the best and worst performing sectors in China’s equity markets (see chart below).

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The differences have been most dramatic between China’s consumption-led ‘new economy’ sectors, which include the Consumer sector and Technology sector, and China’s export-based ‘old economy’ sectors, such as Energy and Materials. These ‘new economy’ sectors have been key drivers of China’s economic growth this year, as domestic consumption accounted for 58% of the country’s GDP growth9. We believe this trend is a long term structural change that will persist into the next decade as China’s economy becomes less dependent on exports and benefits from rising household incomes and expanding middle class.

Implementing these Ideas in a Portfolio

China’s onshore bond market is the third largest in the world and represents 36% of the total Emerging Market debt outstanding10. Investors can consider complementing existing emerging market local debt allocations with the Global X GF China Bond ETF (CHNB) for more representative exposure to the emerging market fixed income opportunity set. CHNB targets bonds that are among the highest credit quality in China, including Government Bonds, Agency Bonds, and bonds issued by state owned enterprises (SOEs).

Investors looking to target China’s equity sectors which could benefit from the transition to its ‘new economy’, can consider the Global X China Consumer ETF (CHIQ) and the Global X Nasdaq China Technology ETF (QQQC). To complete one’s emerging market allocation, investors could supplement these China sector exposures with the Global X Next Emerging and Frontier ETF (EMFM), which invests in emerging and frontier market equities, but excludes the BRICs, South Korea and Taiwan, and therefore will not overlap with QQQC or CHIQ.