Comment: Cause for cautious optimism in China

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Davide Andaloro of Goldman Sachs Asset Management
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Davide Andaloro of Goldman Sachs Asset Management

There is little doubt the covid-19 pandemic will be remembered through time as 2020's black swan - and perhaps one of unprecedented dimensions. Davide Andaloro looks at where it all began, and China's prospects.

The global economy started off the year on a strong footing, with growth set to expand at 3.3% according to the IMF's January forecasts, but in the April's updated forecasts, growth is now set to shrink by 3% in what can be a more severe shock than the Global Financial Crisis. What a difference a quarter can make.

Of course, the spread of the virus has impacted economies at different times year to date. The estimated peak hits are projected to arrive in Q1 for China, and in Q2 for Europe and the US.

As investors consider the road ahead, Chinese equities and bonds seem to offer cause for cautious optimism, against a backdrop of unprecedented uncertainty."

Accordingly, last week China's GDP contracted by -6.8% year-on-year in 1Q, a sharper fall than consensus forecasts of a 6.5% decline, following 6.0% growth in Q4 2019. Nonetheless, early action in containing the virus spread may bear fruit from a growth standpoint, with the IMF still projecting positive growth for 2020 as a whole at +1.2%.

Within this frame, aggregate developed markets (DM) are forecast to contract by 6.1%.

Covid-19 emerged in China and the nation's economy was the first to feel the effects of the economic hit. Now, it also seems to be first in growing out of it - and convincingly so looking at the diverging expected growth performance.

As of 10 April, aggregate demand in China across 20 sectors - from leisure to logistics and smartphone to sportswear - was at 76% of 2019 levels, up from a low of 56% in February, but below the 91% observed in January.

In other words, despite restrictions outside of Wuhan being lifted in early March, activity has not yet fully recovered, with service sector and consumption lagging and potentially normalising only toward late May and June.

Investors are rightly focused on the pace at which activity will return to normal, given that China is today the world's largest trading partner. China's recovery is also being closely watched given its potential to serve as a template for growth paths elsewhere.

Chinese epidemiological and economic developments will also be useful to monitor, even if their magnitudes differ from what we will likely observe in core markets such as the US, Euro area and UK.

In the wake of this shock, investors will be considering the implications on investment in the region. Equities have remained resilient on the back of strong policy support.

As of 17 April, the MSCI China Free Index was outperforming both EMs and DMs, at attractive valuations versus historical levels across Chinese, US and broader DM equities.

Further out, key long-term drivers for investment opportunities remain intact, like the consolidation of China's "old economy" sectors and its focus on technology catch-up via innovation and market-oriented competition.

In fixed income, we believe that Chinese bonds are attractive from both a tactical and a strategic perspective and judging by the amount of interest we currently see from our clients in this asset class we are not alone in this belief.

Looking at DM sovereign rates, the "lower for longer" mode is set to continue for quite some time, as yields remain constrained between policy lower bounds and spillovers from quantitative easing.

China is also set to see some more policy easing to the benefit of returns, but yields should remain meaningfully higher relative to DM peers.

At portfolio level, Chinese bonds exhibit a very low level of correlation to other sovereign bonds, and therefore deliver useful diversification properties.

Longer term, we continue to see structural demand tailwinds due to Chinese bonds being progressively included in major bond indexes like the Barclays Global Aggregate, the JPMorgan GBI-EM Global Diversified and possibly also the FTSE Russell World Government Bond.

Looking at the Barclays Global Aggregate alone, by the end of the implementation period (December 2020) Chinese bonds will be the third biggest index constituent at 6.4%.

In terms of comparison, that is almost a 1pp higher than the percentage of UK equities within the MSCI World Index. Indices are changing and with them, investors' attitude towards Chinese bonds: a phenomenon too big to ignore.

As investors consider the road ahead, Chinese equities and bonds seem to offer cause for cautious optimism, against a backdrop of unprecedented uncertainty.

Davide Andaloro is senior market strategist at Goldman Sachs Asset Management. 

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