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China bond market rally may have legs

Nikkei Asia Review, 4 Nov. 2015, Joe Zhang,

http://asia.nikkei.com/Viewpoints/Perspectives/China-bond-market-rally-may-have-legs

     For about eight years, China banned real estate companies from issuing bonds domestically. More than 50 developers therefore tapped the offshore market in Hong Kong, typically issuing high-yield, or junk, bonds at interest rates of 8-13%.

     Just as many investors were fearing defaults, the ban on domestic issuance was suddenly lifted in July. In the few months since, Chinese property companies have issued hundreds of billions of yuan in bonds that will mature in 3-5 years and pay interest of just 4-8% a year per annum.

     More than a few observers have shouted "Bubble!": how could such large quantities of debt from issuers rated overseas as below investment grade be priced so cheaply, near to the yields of Chinese sovereign debt?

     Before we can be sure of this being a bubble, we have to answer one question: are falling interest rates a trend in China?

     The ingredients are already in place: a sluggish economy and diminished government appetite for fiscal stimulus on the one hand and rising bank credit on the other. The growth of around 13% in broad-money supply month after month confirms monetary conditions are loose.

     When money supply grows too fast, it is an indication of rising inflation to come. But where is the inflection point? Evidence shows the time lag between rising liquidity and higher inflation varies from cycle to cycle and from country to country.

     If inflation is indeed in a long-term downward trend, interest rates and bond yields could continue to fall for a long time. In that scenario, the bond market today may not be in a bubble at all. And indeed, we may be at the starting point of a bond market renaissance that could last a decade.

     What about the equity market? It sounds counterintuitive but famed American investor Warren Buffett has shown that gross domestic product growth is negatively correlated with the performance of the equities market, at least sometimes. In a 2001 speech, Buffett showed that across a long-enough time span, GDP growth did not matter to asset prices and that interest rates were the only thing that counted.

     Overall, the Dow Jones Industrial Average moved a mere one point between 1964 and 1981 while nominal gross national product grew 373%. Over the next 17 years, the Dow surged 10-fold while GNP rose only 177%. What drove the vast difference in equity market performance between the two periods?

     Buffett attributed it to changes in long bond yields. At the end of 1964, yields were 4.20%. They rose to 13.65% by the end of 1981 before falling back to 5.09% by late 1998.
 
     Today while U.S. interest rates are set to rise, Chinese domestic interest rates are probably on their way down. But U.S. interest rates, even after several increases over the next few years, will remain low in absolute terms and by historical standards.

     In this sense, is there not a case to be made for Chinese equities and bonds to outperform?

     As to the lack of correlation between GDP growth and equity market performance, another case comes to mind. From 2000 to 2005, China's economy was exceptionally strong but the domestic stock market was dismal. In my view, this was due to high inflation.

     In the past three decades, the U.S. bond market has performed very strongly due to a long trend of falling inflation and interest rates. Bill Gross, formerly of the Pimco Total Return Fund, was a hero of the long trend.

     While many argue that the U.S. bond market's rise was due largely to the U.S. Federal Reserve's loose monetary policy, in fairness, it had more to do with weaker returns in the underlying economy and lower growth rates.

     All along, observers have described, with a tone of alarm, the rising bond prices and complimentary falling yields as "a bubble", particularly in recent years. Most have stopped in recent months, just as yields on many U.S. and German government bonds fell toward zero or beyond.

     If U.S. experience is any guide, China's bond market should be in for a long rally. However, China's fast-rising corporate debt-to-GDP ratio is alarming. Will the growing pile of debt lead to runaway inflation? If so, when? My honest answer is, I do not know, but the ratio may just reflect statistical anomalies.

     While continued high growth in the money supply will erode the yuan's purchasing power and lead to inflation in the long run, until then we may see an extended bond market rally given the glut in the real estate sector and excessive valuations in the equity market. Retail and institutional investors have to find somewhere to park their money, after all.

Joe Zhang is chairman of China Smartpay Group and author of "Party Man, Company Man: Is China's State Capitalism Doomed?"




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