Jeff Rosenberg discusses China's economic policy and
why it matters to fixed income investors.
- Trees cannot grow to the sky. This most memorable quote from an “authoritative insider’s” editorial outlined what most analysts view as a direct communication of China macro policy intent from President Xi Jinping. Xi appears to directly criticize the recent stimulus policies of China, policies we outline below that stand behind much of the recovery in financial markets since mid-February. If so, this communication holds great importance to the macro outlook questioning the durability of the rally.
- Lather. Rinse. Repeat. China’s pattern of ramping up credit growth in response to a macro economic slowdown is now well familiar. So, too, are the unintended consequences of stoking asset price bubbles, with the latest showing up in Chinese commodity markets. And while financial market concerns appear to have dissipated and commodity and commodity-related credit prices have recovered significantly their recent losses, the fundamental and longer lasting efficacy of such policies underlying the recovery appears increasingly suspect. Consider only the latest crackdown on financial and economic reporting and analysis likely would not be happening if the success of these policies were manifest. The risk that market fear fills the vacuum of knowledge created by the crackdown remains a major downside scenario.
- Why a renminbi devaluation—and the value of the dollar—matters. It’s because the world’s debt is denominated in dollars. And as the dollar gets more expensive, or equivalently as the renminbi cheapens, that debt becomes harder to service. Fears of a massive one-off China devaluation gripped markets in mid–February and the PBOC helped to quell such concerns. For a deval in China wouldn’t stay in China; it would likely force most other emerging markets to devalue. And given that in this cycle that is where the credit vulnerabilities most greatly lie, default expectations go up when those local currency values drop versus the dollar. No wonder, then, that the Federal Reserve now finds itself hard pressed to normalize interest rates anywhere near the four times indicated at the end of last year. Looking forward, it might not even get one.
Strategy and outlook
With a significant recovery in credit markets now behind us, to get to even higher levels requires a return to prices seen last May. That means unwinding the entire risk premium in place in the aftermath of the collapse in expectations for the commodity rebound, as well as the risk premium from China growth and stability fears. While such compression may continue, we anticipate in the best case income with no price appreciation going forward. With limited upside and still considerable downside risks, the pursuit of income tempered by downside risks keeps our outlooks across most risky fixed income assets at neutral this month. We also take down our view on Treasurys this month to underweight, with focus on the front end, where pricing out of Fed tightening may have gone too far. We still express a relative preference for longer-duration exposure.
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