The Weekly Update

It seems China will have to wait another year and push further reforms in order to satisfy the requirements of MSCI that would allow its A-Shares to be classified as Emerging Market. Such a reclassification has been impending for years and last week MSCI again postponed the inevitable – awaiting increased capital market accessibility and transparency. It had seemed more likely now than in previous years considering the accelerated reforms of the past 12 months (which mollified the IMF sufficiently to include the Chinese renminbi into the SDR in November 2015).

MSCI previously specified three outstanding central criteria for China to meet before inclusion. More streamlined and predictable quota allocations expectations seem to have been met, as have clarifications regarding beneficial ownership laws which were a major concern. However, concerns still lingered around the Chinese authorities’ propensity to control their stock markets – epitomised in the 2015 crash and the suspensions of trading spanning large fractions of the Chinese market. Also concerns over the 20% monthly repatriation limit’s effects on mutual funds capacity to deal with large redemptions creates an obstacle to inclusion at present.

Such an eventual inclusion could see China mainland shares being gradually included across their emerging market indices and concurrently in ETFs / funds that benchmark against such indices. Already, despite this decision, the core MSCI emerging market index allocates 25% to Chinese shares (mostly those traded in the United States and Hong Kong) which for the world’s second largest economy is still proportionally underweight; China ‘s GDP is over 7x larger than South Korea’s which currently accounts for over 15% of the MSCI EM Index. Once inclusion is confirmed, a partial allocation of an additional 5% in China A-Shares is the more likely first step. Then following partial implementation the current roadmap estimates China’s proportion of the index increasing to around 44% under a full inclusion scenario – accounting for other expected changes such as South Korea transitioning into the developed market space.

Such a trend has already formed a (somewhat disregarded) discrepancy in China allocations between local currency and dollar denominated indices and ETFs with a number of hard currency emerging market ETFs holding less than 5% in China. Such a distortion could mean that some investors are unwittingly underweight China which adds further potential for flows into China in addition to its eventual designation of emerging market. With MSCI’s decision to postpone inclusion, China A-Shares dropped 1.1% but reversed this loss closing 1.6% stronger - with markets uncertain as to how much of this bounce was driven by Chinese authorities saving face. Such is the dichotomy in China, with its growing economic dominance tarnished by market improprieties. Nevertheless the trend of growth looks set to continue, and once China’s markets mature and it recognises the benefits associated with further integration, the world of indices and ETFs could find themselves playing catch-up.

Meanwhile, unconventional monetary policy and negative rates continue to bring unintended consequences. Globally, more and more sovereign bonds (over USD 10 trillion) now trade on negative yields with the 10 year German bund also joining the club. As negative rates and QE are being pursued policy outcomes are becoming less predictable than might have originally been hoped for. For example, currency moves are not necessarily as central banks predicted: take Japan, where the shift to negative rates earlier in the year was expected to help the currency weaken and boost growth and inflation. In fact the Yen has strengthened, exacerbated by the latest meeting, when the BoJ left policy unchanged and the Yen strengthened breaching the JPY105 level against the US dollar. At the time of writing the Yen is trading at 104.60 to the US dollar; at the moment the market is not heeding attempts by government officials to ‘talk down’ the Yen. The Finance Minister, Taro Aso, called for global coordination to address these disorderly moves in the foreign exchange market.

Japan’s difficulties are also at risk of impacting its credit rating: on 13 June Fitch affirmed Japan’s long-term foreign rating at ‘A’ but revised the outlook to negative from stable. They note the government’s decision to delay the consumption tax increase has not been accompanied with by any offsetting measures thereby reducing Fitch’s confidence in the Japan’s plans for fiscal consolidation. The consumption tax hike was seen as an important driver in helping to bring the primary deficit of the central and local governments into balance in FY20. As a result, Fitch now expects its general gross government debt to GDP estimates to increase by 1-2 percent per annum out to 2024 from 245 percent at the end of 2016.  But we note that while the public debt figures is high it is predominantly domestically financed (Japan has a positive net foreign asset (NFA) position). Offsetting these negatives, Fitch has marginally increased its growth estimates to 0.8 percent from 0.7 percent in 2016 and revised up its 2017 growth forecast to 0.7 percent.

BoJ policy has driven the yield on the 10 year JGB yield to -0.16% at the time of writing. Interestingly, Japanese investors have increased their purchases of overseas bonds buying USD 109.2bn year to date. US Treasuries have particularly been a notable recipient with inflows of USD 57.8bn year to date (30 April figure). Plus, Bank of Tokyo-Mitsubishi UFJ, one of the key primary dealers for JGBs, announced that it was looking to withdraw from this market: while primary dealers have certain privileges they are also required to bid on at least 4% of an issue but this role is perhaps less attractive when the large banks have been reducing their holdings in JGBs. That said, foreign investors have been net buyers of Japanese bonds in 19 out of 23 weeks this year!

For us, Japanese and foreign investors should look at the positive yield on creditor nations and quasi-sovereign exposure in places such as the Middle East and Russia and selective Asian markets which still look amongst the most compelling opportunities in the fixed income markets. For Japanese and European investors in particular, buying high grade US dollar bonds and hedging them back to their base currency provides a compelling alternative to domestic bonds with credit risk and no return whatsoever.