Renminbi Outlook 2016 and Beyond

This short paper outlines the factors that have contributed to the Chinese renminbi’s strength over the past decade. The analysis highlights how these conditions largely persist and require prolonged periods to unwind during which they will continue to exert long-term upward pressure on the currency:

  • China’s large positive net foreign assets position remains an important driver for longer term currency appreciation.
  • Renminbi undervaluation in PPP terms should lessen with China’s relatively faster growth and  rising incomes.
  • PBoC latest goals for high-skilled manufacturing, services and increased domestic consumption are inconsistent with a weakening exchange rate.
  • Weaker global growth points to a softer dollar and relatively stronger renminbi according to its managed FX basket weightings.
  • Significant but often overlooked renminbi interest rate carry cushion provides additional potential return alongside any appreciation.

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Stratton Street Investment Philosophy

For more than 30 years, a combination of receding inflation and increasing leverage has created an extraordinary bull market for bonds that now is coming to a close. Traditional fixed income investors can no longer expect a rising tide of new issuance, low inflation and strong economic growth to keep debtors afloat. A new era of fixed income investment is unfolding that will require more active management to find value in an environment of low yields. Central bank intervention raises the dual spectres of illiquid markets and overvalued asset prices as carry trades and central bank purchases distort prices. New metrics are needed not only for identifying value but also for sorting out vulnerable borrowers from those with a high probability of weathering the new environment of low growth and low inflation.

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Renminbi Inclusion in SDR basket

On the 8th anniversary of the original Renminbi Bond Fund ("RBF"), the Chinese renminbi should finally receive the official global reserve status we have been patiently anticipating.

The number 8 in Chinese culture represents luck, fortune as well as “strong intuition and insight”. For us therefore it seems particularly fortuitous that Monday’s anticipated inclusion of the renminbi into the SDR arrives the same day as the 8th anniversary of our Renminbi Bond Fund.

Launched in 2007, before any other fund of its kind and well before the launch of the Dim Sum market itself, RBF aimed to create a sensible high grade asian bond product with exposure to the appreciation of the Chinese renminbi. The latter on the premise that this highly competitive superpower - accounting for their large reserves, current account and trade surpluses, inflationary pressures and welfare/prosperity aspirations - would pursue a lofty ambition of equal global reserve status with the US dollar.

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Special Report: PBoC Fixing Policy

  • The renminbi depreciation was the natural result of the significant shift in PBoC policy to adjust the renminbi fixing in line with the previous close effectively freeing the currency to market forces yet retaining its ability to avoid shocks from when markets are “distorted”.
  • August 13 PBoC statement strongly confirms that the underlying rationale is not to promote exports but for meeting internationalisation requirements and aspirations to be included in the IMF’s SDR this year. (link: PBoC Statement 13 August 2015)
  • The renminbi is already at a comfortable level for the PBoC and a long term path of appreciation is still expected.
  • Longer term comparison of China with the industrialisation of Japan points to the potential scale of further renminbi appreciation over the coming decades even as growth slows.
  • The move has had a strong positive impact on the bond market, especially in higher grade credit and puts further strain on inflation and growth in the west which is broadly negative for stocks and positive for bonds.

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An Anatomy of a Sell Off - Taper Tantrum II

Bond land looks a little saner now that negative yields are disappearing from the Eurozone landscape. Those elevated prices never made any sense for real money investors, most of whom could not or would not buy bonds that would lock in a capital loss. That certainly is the hard reality for German insurance companies which collectively hold more German debt than any other institutions. Only hedge funds and trading desks that could leverage a carry trade at zero funding cost would bet that the carry would be worth the risk of capital loss. The ‘greater fool’ in this episode had to be the ECB whose belated and oversized asset purchase plans fomented this bond buying folly in the first place. Now bond prices have gone full circle back roughly to where they were prior to the buying frenzy in anticipation of the onset of the PSPP (ECB Euro-system public sector purchase program) in March.

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Déjà vu Deleveraging

  • When oil prices were above $100/barrel (such as 2011 to early 2014) oil companies and their suppliers were the preferred leveraged equity trade
  • Similarly, EM currencies and high yield bonds were the preferred carry trades under zero interest rates policies (ZIRP) and quantitative easing (QE)
  • Oil prices have fallen by more than 40% during 2H 2014. This could have serious implications for vulnerable debt issuers with unsustainable debt levels
  • European corporate debt spreads have held up remarkably well during the sell-off in recent months – likely driven by expectations of monetary policy in the eurozone during Q1, 2015
  • 9 out of 15 of the world’s largest debtors relative to GDP are located within the eurozone
  • The FOMC press release on 17 December included the word ‘patient’ – the first rate hike is therefore likely in April 2015
  • Financial markets already reflect the first rate hike – few bonds with maturities less than 3 years have value (with the exception of Chinese sovereign and quasi-sovereign debt)
  • China’s quest for reserve currency status in 2015 will attract considerable attention. Both equities and the CNY will continue to benefit from lower oil prices

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China's Gordian Policy Knot

  • The renminbi will appreciate 2-3-% per year on average over the next five years. A stronger currency is the only way to limit the high cost of forex sterilization.
  • The PBOC will widen the currency bands whenever hot money flows reappear until they are +/- 5%.
  • The principal drivers of the currency will be China’s current account surplus and China’s status as one of the world’s largest creditors.
  • Greater renminbi flexibility will be accompanied by continued strides to develop local debt instruments.  
  • In contrast with other interest rates, deposit rates will not be deregulated anytime soon.
  • The ongoing internationalization of the renminbi should be viewed as means for lowering the cost of trade transactions rather than a driver of the currency per se.
  • The final phase of China’s financial evolution will lead to substantial overvaluation by as much as 25% to 30%.
  • Complete convertibility including financial flows will be among the last of the financial reforms.

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Does lending to debtors make sense for bond investors

A whole branch of theory of efficient markets has argued that it is efficient to allocate your
money based on the amount of securities outstanding. The more debt a country has, the more
weight they get in the index. As we have seen with Greece, this can lead to an unsustainable
spiral of debt, followed by a sudden default. This paper examines whether net foreign assets, a
measure of a country’s net wealth, can reliably predict future defaults and concludes that
allocating to countries with net wealth, rather than net debt, leads to superior returns for fixed
income investors.

Introduction

Bond indices are constructed using the amount of securities outstanding and therefore gives a
disproportionately high weight to the most indebted companies and countries. As countries and
companies become more indebted, their weight in these indices tends to rise. Left unchecked,
this would result in significant defaults in portfolios of bond investors who track indices
closely. However, this effect ought to be mitigated if rating agencies were to downgrade
countries well in advance of default, giving investors time to adjust their portfolios accordingly.
However, the example of Greece illustrates that rating agencies have been slow to adjust
ratings as economic fundamentals deteriorate. In early 2009, Greece was rated A1 by Moody’s
and A- by Standard & Poor’s. Based on a long series of historical data, such a rating implies a
probability of default of considerably less than one percent within three years.

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