Emerging markets debt perspectives: Adapting to China’s shifting (and slowing) winds

Bottom line up front (BLUF):

• Erratic policy making, falling potential growth, and increasing data quality issues have made analyzing China macro, and its corporate sector, increasingly difficult. Yet, China’s debt market remains too big to ignore.
• We are broadly underweight China but still see favorable risk/reward in long-dated government bonds and select corporate sectors.
• Broadly, China’s impact on emerging markets debt (EMD) remains significant but we believe its influence on the market is waning while new opportunities help balance the risks.

EMD performance review

EMD performance faltered in the third quarter as a rates-driven sell-off took hold amid growing risk-off sentiment and sticky inflationary pressures. The USD reversed recent losses and gained against most emerging- and developed-market currencies. Stronger than expected U.S. growth and a hawkish hold from the Fed in September drove U.S. rates higher. For the full quarter, all EMD segments declined, with local markets underperforming sovereigns and corporates. Much of the decline in sovereigns was driven by rates as longer-duration, higher-quality declined. Local debt was driven primarily by currency (FX) declines (-2.6%) with rates also detracting (-0.7%). In the geopolitical arena, Chinese authorities continued to slowly drip stimulus measures to help shore up confidence in their growth outlook and credit fundamentals. The Ukrainians have made some very modest incremental gains by piercing Russia’s defense line in the occupied south. Ecuadorians went to the polls in August for general elections as incumbent Guillermo Lasso choose not to seek reelection. Advancing to the October runoff are Luisa Gonzalez, who won the highest percentage and, unexpectedly, Daniel Noboa who gathered the second most votes.

We’re not in Henan (Kansas) anymore

While analyzing the Chinese economy has always been difficult, over the past decade and a half market participants could rely on the government’s annual target being met. Under President Xi, a rebalancing has occurred – prioritizing security and self-sufficiency over economic growth. Amid structural issues such as rising leverage, falling potential growth, geopolitical tensions, and more centralized decision making – we’ve seen more unpredictable policymaking while the reaction function has slowed.  Unexpected crackdowns on the property, private education, technology, gaming, financials, and healthcare sectors, on top of the years’ long Zero-Covid policy, amplified headwinds on the private sector. As a result, we think the potential growth has decelerated faster than previously thought. Since then, we’ve have had to constantly re-evaluate and tweak our views on how China directly and indirectly impacts to our portfolios.

Avoiding the debt doldrums

Chinese sovereign bonds boast a strong credit rating (A1/A+) and benefit from supply/demand dynamics for both USD and local currency government bonds – thus keeping volatility low. However, valuations are unattractive with yields below U.S. treasuries. We do believe, however, that there is scope for longer duration local currency treasuries to perform due to very high domestic savings and falling potential growth. On the currency, we think RMB (Renminbi) will continue to trade weak against the USD in the near term (given interest rate differentials) but broadly stable vs other currencies (still high current account surplus). The central bank still has more than sufficient tools (e.g., >$4 trillion FX reserves) and incentive to limit excess depreciation pressure.

We’ve long been cautious on the USD corporate bond market, maintaining an underweight due to valuations and concerns around transparency, overcapacity, structural subordination, and an undeveloped bankruptcy regime. Major state-owned enterprises (SOEs) have relatively healthy balance sheets and benefit from strong state support, however rising geopolitical tensions make us wary of sanctions. Traditionally, we have treaded very cautiously in the property sector but hold modest positions in select mandates, primarily due to the sector’s index weight and high relative yields. We have stayed in the larger, more liquid developers but, given the extent and duration of the property crackdown on top of weakening structural trends, we continue to monitor these positions very closely.

One sector we maintain exposure to is the Macau gaming space. The space has been battered by COVID lockdowns and license renewals from regulators but pre-emptive financing, strong parental support, eventual reopening, and improving mix/profitability led the sector to bounce back strongly with earnings having potential to exceed pre-COVID levels in the coming quarters. Other sectors we’ve liked include TMT, utilities and select HK issuers – targeting names with strong liquidity and/or low financial leverage.

What the tea leaves are saying for China and EM

Given China’s still sizeable fiscal buffers (U.S. $12.5 trillion in assets per IMF¹) and socio-political considerations, a “hard landing” is still a very low probability in our view. The economy appears to be bottoming after continuous announcements of stimulus since early summer. However, we’re skeptical of a meaningful bounce without a significant structural rebalancing to reverse the declining potential growth. Geopolitically, while U.S./China relations have thawed in recent months, we still think the trajectory is negative, as tensions will rise again in 2024 due to Taiwanese and U.S. Presidential elections.

While China continues to have significant economic influence over EMD broadly, we believe that its impact is more balanced relative to the past decade given several factors:

(1) External imbalances are improving as policymakers have become more orthodox².

(2) Commodity producers have turned more disciplined since the 2015 downturn while the oil-producing Gulf countries have rebuilt buffers to become net exporters of capital.

(3) EM sovereign and corporate issuers are much more diversified today, effectively reducing China’s overall beta to the asset class.

(4) The transition to renewables and increasing multipolarity arguably creates more opportunities for EM by creating new supply chains and allowing industries to develop in new countries and regions³.